[Federal Register Volume 70, Number 78 (Monday, April 25, 2005)]
[Proposed Rules]
[Pages 21306-21323]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-8158]



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Part IV





Securities and Exchange Commission





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17 CFR Part 240



Definition of Nationally Recognized Statistical Rating Organization; 
Proposed Rule

  Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / 
Proposed Rules  

[[Page 21306]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release Nos. 33-8570; 34-51572; IC-26834; File No. S7-04-05]
RIN 3235-AH28


Definition of Nationally Recognized Statistical Rating 
Organization

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

ACTION: Proposed rule.

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SUMMARY: The Commission is publishing for comment a proposed new rule 
under the Securities Exchange Act of 1934 (``Exchange Act''), which 
would define the term ``nationally recognized statistical rating 
organization'' (``NRSRO''). The proposed definition contains three 
components that must each be met in order for a credit rating agency to 
be an NRSRO. The Commission is also providing interpretations of the 
proposed definition of the term ``NRSRO.'' Defining the term ``NRSRO'' 
and providing interpretations of the definition would increase 
transparency with regard to the NRSRO concept.

DATES: Comments should be received on or before June 9, 2005.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number S7-04-05 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, 
Washington, DC 20549-0609.
    All submissions should refer to File Number S7-04-05. This file 
number should be included on the subject line if e-mail is used. To 
help us process and review your comments more efficiently, please use 
only one method. The Commission will post all comments on the 
Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for public inspection and 
copying in the Commission's Public Reference Room, 450 Fifth Street, 
NW, Washington, DC 20549. All comments received will be posted without 
change; we do not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly.

FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate 
Director, at (202) 942-0132; Thomas K. McGowan, Assistant Director, at 
(202) 942-4886; Randall W. Roy, Branch Chief, at (202) 942-0798; Mark 
M. Attar, Special Counsel, at (202) 942-0766; or Rachael Grad, 
Attorney, at (202) 942-0183, Division of Market Regulation, Securities 
and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-
1001.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
II. The Development of the NRSRO Concept
    A. Background
    B. History of the NRSRO Concept
    C. Commission Reviews of Credit Rating Agencies
    1. 1994 Concept Release
    2. 1997 Rule Proposal
    3. Recent Reviews of Credit Rating Agencies
    a. NRSRO Examinations
    b. Credit Rating Agency Hearings
    c. Report under the Sarbanes-Oxley Act of 2002
    d. The 2003 NRSRO Concept Release
    D. International Initiatives
III. Discussion
    A. Background
    B. Proposed Definition of the Term ``NRSRO''
    1. The First Component
    a. Publicly Available Credit Ratings
    b. Issue-Specific Credit Opinions
    c. Current Credit Opinions
    2. The Second Component
    a. General Acceptance in the Financial Markets
    b. Limited Coverage NRSROs
    3. The Third Component
    a. Analyst Experience and Training
    b. Number of Ratings per Analyst
    c. Information Sources Used in the Ratings Process
    d. Contacts with Management
    e. Organizational Structure
    f. Conflicts of Interest
    g. Misuse of Information
    h. Financial Resources
    i. Standardized Rating Symbols
    C. Statistical Models
    D. Provisional NRSRO Status
    E. Staff No-Action Process
IV. General Request for Comment
V. Paperwork Reduction Act
VI. Consideration of the Costs and Benefits of the Proposed Rule
    A. Benefits
    B. Costs
VII. Consideration on Burden and Promotion of Efficiency, 
Competition, and Capital Formation
VIII. Consideration of Impact on the Economy
IX. Regulatory Flexibility Act
X. Statutory Authority

I. Introduction

    In June 2003, the Commission issued a concept release (the ``2003 
Concept Release'') soliciting public comment on various issues 
regarding 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.\1\ To address certain issues raised in response 
to the 2003 Concept Release, particularly with regard to the clarity of 
whether a credit rating agency is an NRSRO, the Commission is proposing 
to define the term ``NRSRO'' in new Exchange Act Rule 3b-10, and to 
provide interpretations of that definition. The Commission notes that 
this proposal is intended only to address the meaning of the term 
``NRSRO'' as it is used by the Commission; it does not attempt to 
address many of the broader issues raised in response to the 2003 
Concept Release.
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    \1\ Securities Act Release No. 33-8236), 68 FR 35258 (June 12, 
2003). The 2003 Concept Release was intended to assist the 
Commission in addresing issues identified in its January 24, 2003 
report on credit rating agencies, which was required by Congress 
under Section 702 of the Arbanes-Oxley Act of 2002. See report on 
the Role and Function of Credit Rating AGencies in the operation of 
the Securities Markets, As Required by Seciton 7029b) of the 
Sarbanes-Oxley Act of 2002, U.S. Securities and Exchange Commission, 
January 2003.
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II. The Development of the NRSRO Concept

A. Background

    Since 1975, the Commission has relied in several significant 
regulatory areas on credit ratings by rating agencies that the markets 
have recognized as credible. These ``nationally recognized statistical 
rating organizations,'' or ``NRSROs,'' have typically sought a level of 
comfort regarding their status as NRSROs through the no-action letter 
process.\2\ To date, nine firms have been identified as NRSROs by the 
Commission staff. However, during the 1990s, several credit rating 
agencies consolidated so that there are currently five such NRSROs: 
A.M. Best Company, Inc. (``A.M. Best''), Dominion Bond Rating Service 
Limited (``DBRS''); Fitch,

[[Page 21307]]

Inc. (``Fitch''); Moody's Investors Service Inc. (``Moody's''); and the 
Standard & Poor's Division of the McGraw Hill Companies, Inc. 
(``S&P'').
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    \2\ See, e.g., Letter from Annette L. Nazareth, Director, 
Division of Market Regulation, Commission, to Mari-Anne Pisarri, 
Pickard and Djinis LLP (February 24, 2003). For a more detailed 
description of the no-action letter process, see also Section III.E.
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    Although the Commission originated the use of the term ``NRSRO'' 
for use in its rules and regulations, ratings by NRSROs today are used 
as benchmarks in federal and state legislation, rules issued by 
financial and other regulators, foreign regulatory schemes, and private 
financial contracts. Many of these uses specifically refer to the term 
``NRSRO'' as used in the Commission's rules and regulations. However, 
the Commission has never defined the term ``NRSRO.''

B. History of the NRSRO Concept

    The term ``NRSRO'' was originally adopted by the Commission in 1975 
solely for use in determining capital charges on different grades of 
debt securities under Exchange Act Rule 15c3-1, the Commission's ``net 
capital rule.'' \3\ The use of this term enabled the Commission to 
distinguish between investment grade and non-investment grade paper in 
a reasonably objective fashion. 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 deductions, often referred to as ``haircuts,'' are 
intended to provide a margin of safety against losses that might be 
incurred by broker-dealers as a result of market fluctuations in the 
prices of, or lack of liquidity in, their proprietary 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 credit rating agency of national repute, because those 
securities typically were more liquid and less volatile in price than 
securities that were not so highly rated.\4\
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    \3\ See Adoption of Amendments to Rule 15c3-1 and Adoption of 
Alternative Net Capital Requirement for Certain Brokers and Dealers, 
Release No. 34-11497 (June 26, 1975), 40 FR 29795 (July 16, 1975).
    \4\ See, e.g., 17 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H).
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    Over time, as marketplace and regulatory reliance on credit ratings 
increased, the Commission's use of the NRSRO concept as a proxy for 
regulatory determinations of liquidity and creditworthiness became more 
widespread.\5\ Several rules and regulations issued by the Commission 
pursuant to the Securities Act of 1933,\6\ the Exchange Act,\7\ and the 
Investment Company Act of 1940,\8\ utilize the term ``NRSRO'' and 
cross-reference to the net capital rule. For example, Rule 2a-7 under 
the Investment Company Act of 1940 limits money market funds to 
investing in only high quality short-term instruments, and NRSRO 
ratings can be used as benchmarks for establishing minimum quality 
investment standards. Under Rule 2a-7, a money market fund is limited 
to investing in securities rated by an NRSRO in the two highest ratings 
categories for short-term debt (or unrated securities of similar 
quality), and there are limitations on the amount of securities the 
fund can hold that are not rated in the highest rating category (or are 
not unrated securities of similar quality).\9\ In addition, in 
regulations adopted by the Commission under the Securities Act of 1933, 
offerings of certain nonconvertible debt, preferred securities, and 
asset-backed securities that are rated investment grade by at least one 
NRSRO can be registered on Form S-3--the Commission's ``short-form'' 
registration statement--without the issuer satisfying a minimum public 
float test.\10\
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    \5\ The NRSRO concept is currently used 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-
3a(b)(1)(i)(C), 240.15c3-1f(d), 240.15c3-3a, Item 14, Note G, 
242.101(c)(2), 242.102(d), 242.300(k)(3) and (1)(3), 270.2a-
7(a)(10), 270.3a-7(a)(2), 270.5b-3(c), and 270.10f-3(a)(3).
    \6\ See Regulation S-B (17 CFR 228.10) and Regulation S-K (17 
CFR 229.10); Rule 134 (17 CFR 230.134); Rule 436 (17 CFR 230.436); 
Form S-3 (17 CFR 239.13); Form F-2 (17 CFR 239.32); and Form F-3 (17 
CFR 239.33).
    \7\ See Rule 3a1-1 (17 CFR 240.3a1-1); Rule 10b-10 (17 CFR 
240.10b-10); Rules 101 and 102 of Regulation M (17 CFR 242.101 and 
242.102, respectively); and Rule 300 of Regulation ATS (17 CFR 
242.300).
    \8\ See Rule 2a-7 (17 CFR 270.2a-7); Rule 3a-7 (17 CFR 270.3a-
7); Rule 5b-3 (17 CFR 270.5b-3); and Rule 10f-3 (17 CFR 270.10f-3).
    \9\ Under Rule 2a-7 (17 CFR 270.2-7), NRSRO ratings are minimum 
requirements; fund advisers must also make an independent 
determination that the security presents ``minimal credit risks.''
    \10\ Form S-3 (17 CFR 239.13).
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    In addition, Congress has incorporated the term ``NRSRO'' into a 
wide range of legislation.\11\ For example, when Congress defined the 
term ``mortgage related security'' in Section 3(a)(41) of the Exchange 
Act,\12\ as part of the Secondary Mortgage Market Enhancement Act of 
1984,\13\ it required, among other things, that such securities be 
rated in one of the two highest rating categories by at least one 
NRSRO.
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    \11\ See, e.g., 15 U.S.C. 78c(a)(41) (defining the term 
``mortgage related security''); 15 U.S.C. 78c(a)(53)(A) (defining 
the term ``small business related security''); and 15 U.S.C. 80a-
6(a)(5)(A)(iv)(I) (exempting certain companies from the provisions 
of the Investment Company Act of 1940); Gramm-Leach-Bliley Act, Pub. 
L. 106-102 (1999); Transportation Equity Act for the 21st Century, 
Pub. L. 105-178 (1998); Reigle Community Development and Regulatory 
Improvement Act of 1994, Pub. L. 103-325 (1994); Department of 
Commerce, Justice, and State, The Judiciary, and Related Agencies 
Appropriations Act, FY2001, Pub. L. 106-553 (2000); Higher Education 
Amendments of 1992, Pub. L. 102-325 (1992); Housing and Community 
Development Act of 1992, Pub. L. 102-550 (1992); Federal Deposit 
Insurance Corporation Improvement Act of 1991, Pub. L. 102-242 
(1991); and Financial Institutions Reform, Recovery, and Enforcement 
Act of 1989, Pub. L. 101-72 (1989).
    \12\ 15 U.S.C. 78c(a)(41).
    \13\ Pub. L. 98-440, 101, 98 Stat. 1689 (1984).
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    Finally, a number of other federal, state, and foreign laws and 
regulations today use the term ``NRSRO.'' For example, the U.S. 
Department of Education uses ratings from NRSROs to set standards of 
financial responsibility for institutions that wish to participate in 
student financial assistance programs under Title IV of the Higher 
Education Act of 1965, as amended.\14\ In addition, several state 
insurance codes rely on NRSRO ratings in determining appropriate 
investments for insurance companies.\15\ The term ``NRSRO'' also has 
been used in foreign jurisdictions.\16\
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    \14\ 20 U.S.C. 1070 et seq. and 42 U.S.C. 2751 et seq., 34 CFR 
668.15(b)(7)(ii) and (8)(ii).
    \15\ For example, the California Insurance Code relies on NRSRO 
ratings in allowing California-incorporated insurers to invest 
excess funds in certain types of investments. See Cal. Ins. Code 
1192.10.
    \16\ See, e.g., National Instrument 71-101, The 
Multijurisdicitional Disclosure System (Oct. 1, 1998) (Can.).
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    In 1975, when NRSRO ratings first were incorporated in the net 
capital rule, the Commission staff determined that the ratings of S&P, 
Moody's, and Fitch were used nationally, and that the staff would raise 
no questions if these firms were utilized as NRSROs for purposes of the 
net capital rule.\17\ Since 1975, the Commission staff has issued NRSRO 
no-action letters \18\ to six additional credit rating agencies: (1) 
Duff and Phelps, Inc.; \19\ (2) McCarthy, Crisanti & Maffei, Inc.; \20\ 
(3) IBCA Limited and its subsidiary, IBCA, Inc.; \21\

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(4) Thomson BankWatch, Inc.; \22\ (5) DBRS; \23\ and (6) A.M. Best.\24\ 
With the exception of A.M. Best and DBRS, each of these additional 
firms has since merged with or been acquired by other NRSROs, resulting 
in five NRSROs at present.
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    \17\ See, e.g., Letter from Gregory C. Yadley, Staff Attorney, 
Division of Market Regulation, Commission, to Ralph L. Gosselin, 
Treasurer, Coughlin & Co., Inc. (November 24, 1975).
    \18\ For a discussion of the no-action letter process, see 
Section III.E.
    \19\ See Letter from Nelson S. Kibler, Assistant Director, 
Division of Market Regulation, Commission, to John T. Anderson, 
Esquire, Lord, Bissell & Brook, on behalf of Duff & Phelps, Inc. 
(February 24, 1982).
    \20\ See Letter from Michael A. Macchiaroli, Assistant Director, 
Division of Market Regulation, Commission, to Paul McCarthy, 
President, McCarthy, Crisanti & Maffei, Inc. (September 13, 1983).
    \21\ See Letter from Michael A. Macchiaroli, Assistant Director, 
Division of Market Regulation, Commission, to Robin Monro-Davies, 
President, IBCA Limited (November 27, 1990) and Letter from Michael 
A. Macchiaroli, Assistant Director, Division of Market Regulation, 
Commission, to David L. Lloyd, Jr., Dewey Ballentine, Bushby, Palmer 
& Wood (October 1, 1990).
    \22\ See Letter from Michael A. Macchiaroli, Assistant Director, 
Division of Market Regulation, Commission, to Gregory A. Root, 
President, Thomson BankWatch, Inc. (August 6, 1991) and Letter from 
Michael A. Macchiaroli, Associate Director, Division of Market 
Regulation, Commission, to Lee Pickard, Pickard and Djinis LLP 
(January 25, 1999).
    \23\ See supra note 2.
    \24\ See Letter from Mark M. Attar, Special Counsel, Division of 
Market Regulation, Commission, to Arthur Snyder, President, A.M. 
Best (March 3, 2005).
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    The Commission has not adopted a definition of the term ``NRSRO.'' 
However, through experience from the no-action process, the Commission 
staff has developed a number of criteria that it considers when 
reviewing NRSRO no-action requests. As a result, under current 
practice, the Commission staff reviews a credit rating agency's 
operations, position in the marketplace, and other specific factors to 
determine whether to grant a no-action letter.
    In determining whether to issue an NRSRO no-action letter, the 
Commission staff has considered the single most important factor to be 
whether the credit rating agency is ``nationally recognized'' in the 
United States as an issuer of credible and reliable ratings by the 
predominant users of securities ratings. The notion of ``national 
recognition'' was designed to help ensure that credit ratings used for 
regulatory purposes under Commission rules are credible and can 
reasonably be relied upon by the marketplace. Also reviewed in 
connection with the no-action letter process is a credit rating 
agency's operational capability and ratings process. Included within 
this assessment are: (1) The organizational structure of the credit 
rating agency; (2) the credit rating agency's financial resources; (3) 
the size and quality of the credit rating agency's staff; (4) the 
credit rating agency's independence from the companies it rates; (5) 
the credit rating agency's rating procedures; and (6) whether the 
credit rating agency has internal procedures to prevent the misuse of 
nonpublic information and whether those procedures are followed.

C. Commission Reviews of Credit Rating Agencies

1. 1994 Concept Release
    Over the years, the Commission has reviewed a number of issues 
regarding credit rating agencies, including their regulatory oversight. 
In 1994, the Commission issued a concept release soliciting public 
comment on the Commission's use of NRSRO ratings (the ``1994 Concept 
Release'').\25\ Due to the expanded role played by credit ratings in 
Commission rules and regulations, a number of domestic and foreign 
credit rating agencies at that time had sought NRSRO no-action letters. 
Also, concerns had been expressed that Commission rules and regulations 
did not define the term ``NRSRO,'' and that there was no formal 
mechanism for monitoring the activities of NRSROs. As a result, the 
Commission solicited public comment on the appropriate role of credit 
ratings in the federal securities laws, and the need to establish 
formal procedures for identifying NRSROs and monitoring their 
activities. Most commenters supported the continued use of the NRSRO 
concept and recommended that the Commission adopt a formalized process 
for identifying NRSROs.\26\
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    \25\ See Nationally Recognized Statistical Rating Organizations, 
Release No. 34-34616 (August 31, 1994), 59 FR 46314 (September 7, 
1994).
    \26\ See, e.g., Letter from Walter J. Schroeder, President, 
DBRS, to Jonathan G. Katz, Secretary, Commission (December 20, 
1994).
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2. 1997 Rule Proposal
    As a response to the 1994 Concept Release, the Commission, in 1997, 
proposed to amend the net capital rule to define the term ``NRSRO.'' 
\27\ The proposed amendments set forth criteria to be considered by the 
Commission in recognizing credit rating agencies as NRSROs, and would 
have established an NRSRO application process for credit rating 
agencies.
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    \27\ 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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    Although commenters generally supported the Commission's attempt to 
define the requirements necessary for a credit rating agency to be 
identified as an NRSRO, the Commission did not act upon the 1997 rule 
proposal described above as a result of, among other things, the 
initiation of broad-based Commission and Congressional reviews of 
credit rating agencies.
3. Recent Reviews of Credit Rating Agencies
    More recently, the Commission has pursued several approaches to 
conduct a thorough and meaningful study of the use of credit ratings in 
the federal securities laws, the process of determining which credit 
ratings should be used for regulatory purposes, and the level of 
oversight to apply to credit rating agencies. Commission efforts 
included discussions with credit rating agencies and market 
participants, including buy-side firms,\28\ formal examinations of each 
of the NRSROs, and public hearings that offered a broad cross-section 
of market participants the opportunity to communicate their views on 
credit rating agencies and their role in the capital markets.
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    \28\ Retail investor participation in the debt markets often 
takes place indirectly through buy-side firms, such as investment 
companies.
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a. NRSRO Examinations
    On March 19, 2002, the Commission issued an Order directing 
investigation, pursuant to Section 21(a) of the Exchange Act, into the 
role of credit rating agencies in the U.S. securities markets.\29\ The 
purpose of the Order was to ascertain facts, conditions, practices, and 
other matters relating to the role of credit rating agencies in the 
U.S. securities markets, and to aid the Commission in assessing whether 
to continue to use credit ratings in its rules and regulations under 
the federal securities laws and, if so, the categories of acceptable 
credit ratings and the appropriate level of regulatory oversight.
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    \29\ See 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).
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    The Commission's examination of the NRSROs revealed several 
concerns, including those relating to: (i) Potential conflicts of 
interest caused by payment by issuers to NRSROs for their ratings; (ii) 
exacerbation of those conflicts of interest due to the marketing by the 
NRSROs of ancillary services to issuers, such as pre-rating assessments 
and corporate consulting; (iii) the potential for the NRSROs, given 
their substantial power in the marketplace, to improperly pressure 
issuers to pay for ratings; (iv) the potential for the NRSROs, given 
their substantial power in the marketplace, to improperly pressure 
issuers to purchase ancillary services; (v) the effectiveness of the 
NRSROs' existing policies and procedures designed to protect 
confidential information; and (vi) difficulties in the Commission's 
examinations of NRSROs from, among other things, the lack of 
recordkeeping requirements tailored to NRSRO activities, the NRSROs' 
assertions that the document retention and production requirements of 
the Investment Advisers Act of 1940 are inapplicable to the credit 
rating business, and their claims that the First Amendment shields the 
NRSROs from producing certain documents to the Commission.

[[Page 21309]]

b. Credit Rating Agency Hearings
    The Commission's broad-based study of credit rating agencies 
included public hearings held on November 15 and 21, 2002, that 
addressed credit rating agencies operating in U.S. securities 
markets.\30\ Panel participants represented various views, including 
those of credit rating agencies, broker-dealers, buy-side firms, 
issuers, and the academic community.
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    \30\ 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) (``SEC 
Hearing on Credit Rating Agencies''). Full hearing transcripts are 
available on the Commission's Web site at http://www.sec.gov/spotlight/ratingagency.htm [hereinafter ``SEC Hearing Transcript''].
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    Topics addressed during the hearings included the current role and 
functioning of credit rating agencies, information flow in the credit 
rating process, concerns regarding credit rating agencies (e.g., 
potential conflicts-of-interest), and the regulatory treatment of 
credit rating agencies (including concerns regarding potential barriers 
to entry).
    Most hearing participants favored the regulatory use of credit 
ratings issued by NRSROs as a simple, efficient benchmark of credit 
quality, and suggested that regulatory standards for NRSROs were 
necessary for this concept to have meaning and reliability.\31\
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    \31\ See, e.g., SEC Hearing Transcript, supra note 30 (November 
15, 2002) (testimony of Gregory A. Root, Executive Vice President, 
DBRS).
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    Many participants expressed concern about the existing NRSRO no-
action letter process.\32\ Suggestions to improve the process included 
(i) that the Commission should specify the information credit rating 
agencies should provide when requesting NRSRO no-action letters; and 
(ii) that the Commission review the staff's work in evaluating 
satisfaction of the NRSRO criteria.\33\ Some suggested that NRSRO no-
action requests be completed in a more timely fashion and some noted 
that the Commission might promote competition in the credit rating 
industry by explicitly permitting credit rating agencies that 
specialize in particular sectors to receive NRSRO no-action 
letters.\34\
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    \32\ See, e.g., Written Statement of Paul Saltzman, Executive 
Vice President and General Counsel, The Bond Market Association), 
SEC Hearing on Credit Rating Agencies, supra note 30 (November 21, 
2002).
    \33\ Id.
    \34\ See, e.g., Written Statement of Yasuhiro Harada, Senior 
Executive Managing Director, Rating and Investment Information, 
Inc., SEC Hearing on Credit Rating Agencies, supra note 30 (November 
21, 2002).
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    Some ratings users and issuers suggested that the Commission 
consider more substantive regulation of credit rating agencies (e.g., 
to address potential conflicts of interest), and engage in more active 
oversight of them (e.g., monitoring compliance with the NRSRO 
criteria).\35\
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    \35\ See, e.g., Written Statement of Amy Lancellotta, Senior 
Counsel, Investment Company Institute, SEC Hearing on Credit Rating 
Agencies, supra note 30 (November 21, 2002).
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    Concerns were raised by hearing participants regarding the special 
access of subscribers to credit rating agency personnel, particularly 
given the exclusion from Regulation FD available for disclosures to 
credit rating agencies.\36\ While the larger credit rating agencies 
make ratings and the basic rating rationale available simultaneously to 
subscribers and non-subscribers, subscribers may also have direct 
access to credit rating agency analysts.\37\ Because of this direct 
access, there is a greater risk that nonpublic material information may 
be communicated to subscribers.
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    \36\ See, e.g., SEC Hearing Transcript, supra note 30 (November 
15, 2002) (testimony of Malcolm S. Macdonald, Vice President--
Finance and Treasurer, Ford Motor Company). See also Selective 
Disclosure and Insider Trading, Release No. 34-43154 (August 15, 
2000), 65 FR 51716 (August 24, 2000). Generally, Regulation FD 
prohibits an issuer of securities, or persons acting on behalf of 
the issuer, from communicating material nonpublic information to 
certain enumerated persons--in general, securities market 
professionals or others who may use the information for trading--
unless the information is publicly disclosed. When Regulation FD was 
adopted, the Commission exempted credit rating agencies--not just 
NRSROs--from Regulation FD, on the condition that the material 
nonpublic information is communicated to a credit rating agency 
solely for the purpose of developing a credit rating and that the 
rating is publicly available. In addition to the specific rating 
agency exemption in Regulation FD, credit rating agencies may be 
able to avail themselves of the exemption for ``persons who 
expressly agree to maintain the disclosed information in 
confidence.'' 17 CFR 243.100(b)(2)(ii).
    \37\ Id.
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c. Report Under the Sarbanes-Oxley Act of 2002
    Coincident with these Commission initiatives, Congress in Section 
702 of the Sarbanes-Oxley Act of 2002, required that the Commission 
conduct a study of credit rating agencies and submit a report on that 
study to the President and Congress (the ``Report''). The Commission 
submitted the Report to the President and Congress on January 24, 
2003.\38\ The Report addressed, among other things, 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.\39\
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    \38\ See supra note 1.
    \39\ Sarbanes-Oxley Act of 2002, Pub. L. 107-204, Section 
702(b), 116 Stat. 745 (2002).
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d. The 2003 NRSRO Concept Release
    To further assist the Commission in addressing issues identified in 
the Report, the Commission published the 2003 Concept Release on June 
4, 2003, seeking comment on a number of issues relating to credit 
rating agencies. These issues included 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. Issues discussed during the Commission's two 
days of public hearings on credit rating agencies were also addressed 
in the 2003 Concept Release.
    Most of the 46 commenters responding to the 2003 Concept Release 
supported retention of the NRSRO concept. They generally represented 
that, among other things, eliminating the NRSRO concept would be 
disruptive to the capital markets,\40\ and would be costly and 
complicated to replace.\41\ Only four commenters supported elimination 
of the concept,\42\ and there was limited discussion of regulatory 
alternatives.\43\
---------------------------------------------------------------------------

    \40\ See, e.g., Letter from Leo C. O'Neill, President, Standard 
& Poor's, to Jonathan G. Katz, Secretary, Commission (July 28, 
2003).
    \41\ See, e.g., Letter from Gregory V. Serio, Superintendent, 
New York Insurance Department, Chair, NAIC Rating Agency Working 
Group, National Association of Insurance Commissioners, to 
Commission (July 28, 2003).
    \42\ See, e.g., Letter from Lawrence J. White, Professor of 
Economics, Stern School of Business, New York University, to 
Commission (July 25, 2003).
    \43\ See, e.g., Letter from Frank Partnoy, University of San 
Diego School of Law, to Jonathan G. Katz, Secretary, Commission 
(July 28, 2003).
---------------------------------------------------------------------------

    Most commenters supported improving the clarity of the process for 
identifying NRSROs to the extent credit ratings continue to be relied 
upon in Commission rules. Specifically, commenters generally supported 
the Commission's suggestions to specify more detail in what credit 
rating agencies need to provide to obtain an NRSRO no-action 
letter.\44\ Some also generally supported greater transparency 
regarding the NRSRO concept, for example, by identifying

[[Page 21310]]

NRSROs through Commission action versus the existing no-action letter 
process.\45\
---------------------------------------------------------------------------

    \44\ See, e.g., Letter from Barbara Roper, Director of Investor 
Protection, Consumer Federation of America, to Jonathan G. Katz, 
Secretary, Commission (July 28, 2003).
    \45\ See, e.g., Letter from Steven C. Nelson, Director of 
Taxable Money Market Research, Fidelity Investments Money 
Management, Inc., to Jonathan G. Katz, Secretary, Commission (July 
25, 2003).
---------------------------------------------------------------------------

    A few commenters represented that the current NRSRO criteria, as 
set forth in the 2003 Concept Release, create barriers to entry for new 
entrants and that the standards for determining NRSRO status should be 
lowered.\46\ Others disagreed and represented that the current NRSRO 
criteria should not be diluted.\47\ Most commenters supported NRSRO 
criteria designed to limit conflicts of interest in the credit rating 
business.\48\ There was also general support for recognizing credit 
rating agencies that confine their activities to a limited sector of 
the debt market \49\ or a limited geographic area.\50\
---------------------------------------------------------------------------

    \46\ See, e.g., Letter from LACE Financial Corp. (July 25, 
2003).
    \47\ See, e.g., Letter from Grace Hinchman, Senior Vice 
President, Public Affairs, Financial Executives International, to 
Jonathan G. Katz, Secretary, Commission (July 25, 2003).
    \48\ See, e.g., Letter from John M. Ramsey, Senior Vice 
President and Regulatory Counsel, The Bond Market Association, to 
Jonathan G. Katz, Secretary, Commission (July 28, 2003).
    \49\ See, e.g., Letter from Jeffrey P. Neubert, President and 
CEO, The New York Clearing House Association L.L.C., to Jonathan G. 
Katz, Secretary, Commission (July 31, 2003).
    \50\ See, e.g., Letter from Naohiko Matsuo, Director for 
International Financial Markets, Financial Services Agency, 
Government of Japan, to Jonathan G. Katz, Secretary, Commission 
(July 25, 2003).
---------------------------------------------------------------------------

    Most commenters supported the concept of regulatory oversight of 
NRSROs, at a minimum, to determine whether a credit rating agency 
continues to meet the NRSRO criteria on an ongoing basis.\51\ 
Commenters also recommended that NRSROs should be subject to periodic 
Commission examinations.\52\
---------------------------------------------------------------------------

    \51\ See, e.g., Letter from Amy B.R. Lancellotta, Senior 
Counsel, Investment Company Institute, to Jonathan G. Katz, 
Secretary, Commission (July 28, 2003).
    \52\ See, e.g., supra note 41.
---------------------------------------------------------------------------

D. International Initiatives

    In recent years, there have also been several international 
initiatives involving credit rating agencies. In February 2003, the 
Technical Committee of the International Organization of Securities 
Commissions (``IOSCO''),\53\ of which the Commission is a member, 
created a task force to study issues concerning credit rating agencies, 
and in September 2003 IOSCO published ``Principles Regarding the 
Activities of Credit Rating Agencies,'' \54\ a set of high-level 
objectives for regulators, credit rating agencies, and other market 
participants. In February 2004, the IOSCO Technical Committee formed a 
Chairmen's Task Force for the purpose of developing a voluntary code of 
conduct for credit rating agencies providing guidance on ways credit 
rating agencies could implement the Principles in practice, leading to 
the December 2004 publication by IOSCO of a ``Code of Conduct 
Fundamentals for Credit Rating Agencies.'' \55\ The Code, among other 
things, addresses how credit rating agencies can protect their 
analytical independence, eliminate or manage conflicts of interest, and 
help ensure the confidentiality of nonpublic information shared with 
them by issuers.
---------------------------------------------------------------------------

    \53\ IOSCO consists of 175 securities market regulators that 
have agreed to cooperate in order to promote high standards of 
regulation and to maintain efficient and sound domestic and 
international securities markets.
    \54\ ``IOSCO Statement of Principles Regarding the Activities of 
Credit Rating Agencies,'' The Technical Committee, IOSCO (September 
25, 2003). See also ``Report on the Activities of Credit Rating 
Agencies,'' The Technical Committee, IOSCO (September 2003).
    \55\ See ``Code of Conduct Fundamentals for Credit Rating 
Agencies,'' The Technical Committee of IOSCO (December 2004).
---------------------------------------------------------------------------

III. Discussion

A. Background

    The Commission is proposing to define the term ``NRSRO'' in new 
Exchange Act Rule 3b-10. The proposed definition would be composed of 
three components, which the Commission preliminarily believes to be the 
most important criteria in determining whether an entity's ratings 
should be relied upon for purposes of the securities laws and 
Commission rules and regulations. In addition, the Commission is 
providing interpretations of the proposed definition.
    Specifically, the Commission is proposing to define the term 
``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, and prevent the misuse of nonpublic information, and has 
sufficient financial resources to ensure compliance with those 
procedures.
    The components of the proposed definition are designed to determine 
those credit rating agencies whose ratings are sufficiently reliable to 
be used for a variety of regulatory purposes, such as for purposes of 
the net capital rule. For example, the principal purposes of the net 
capital rule are to protect customers and other market participants 
from broker-dealer failures and to enable those firms that fall below 
the minimum net capital requirements to liquidate in an orderly fashion 
without the need for a formal proceeding or financial assistance from 
the Securities Investor Protection Corporation. The net capital rule 
requires different minimum levels of capital based upon the nature of 
the firm's business and whether the broker-dealer handles customer 
funds or securities. In relying on credit ratings believed to be 
sufficiently reliable, the Commission is using those ratings as a means 
to evaluate the liquidity as well as the creditworthiness of certain 
securities held by a broker-dealer in establishing a sufficient capital 
cushion.

B. Proposed Definition of the Term ``NRSRO''

1. The First Component
    The first component of the proposed NRSRO definition would limit 
the definition to entities that issue publicly available credit ratings 
that are current assessments of the creditworthiness of obligors with 
respect to specific securities or money market instruments.
a. Publicly Available Credit Ratings
    In the 2003 Concept Release, the Commission inquired whether it 
should address concerns that certain credit rating agencies make their 
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 ratings for regulatory purposes. The 
majority of commenters agreed that credit rating agencies whose ratings 
are used for regulatory purposes under the Commission's rules and 
regulations should agree to make public dissemination of their ratings 
on a widespread basis at no cost.\56\
---------------------------------------------------------------------------

    \56\ See, e.g., Letter from Denise Voigt Crawford, Securities 
Commissioner, Texas State Securities Board, to Jonathan G. Katz, 
Secretary, Commission (July 28, 2003).
---------------------------------------------------------------------------

    Commenters generally represented that the publication of credit 
ratings (i) enhances the transparency and efficiency of the market, 
(ii) helps prevent potential selective disclosure of material nonpublic 
information obtained by a credit rating agency under Regulation FD, and 
(iii) and allows for

[[Page 21311]]

ratings comparability.\57\ The commenters also said that a credit 
rating should not be considered to be ``publicly disseminated'' if 
access to it is not readily available on a widespread basis.\58\
---------------------------------------------------------------------------

    \57\ See, e.g., Letter from Raymond McDaniel, President, 
Moody's, to Jonathan G. Katz, Secretary, Commission (July 28, 2003).
    \58\ Id.
---------------------------------------------------------------------------

    One commenter noted that a credit rating agency should not be 
required to disclose ratings to the public when there is a specific 
prior agreement between the credit rating agency and an issuer as to 
certain prescribed conditions for not publishing the issuer's rating 
(e.g., in the case of ``private'' ratings, in which a credit rating 
agency agrees to provide its rating of an issuer only to the 
issuer).\59\ Another commenter suggested that NRSROs should permit 
others, such as publishers of financial information, to freely 
distribute new rating information without limitations.\60\ One 
commenter also cautioned the Commission against involving itself in the 
determination of an NRSRO's pricing models.\61\ This commenter 
represented that NRSROs should be allowed to charge whatever price the 
market will bear.\62\ Another commenter expressed concern that 
requiring NRSROs to publish their credit ratings at no cost may result 
in higher prices for issuers and others who pay for an NRSRO's 
services.\63\
    In response to these comments, the Commission is proposing that, in 
order to meet the definition of the term ``NRSRO,'' a credit rating 
agency must issue credit ratings that are publicly available. The 
Commission is also interpreting ``publicly available,'' as used in the 
definition, to mean that credit ratings used for regulatory purposes 
under Commission rules must be disseminated on a widespread basis at no 
cost. In this context, the rating could be published in a readily 
accessible manner on the credit rating agency's internet Web site. The 
Commission believes that it is important for credit ratings used for 
regulatory purposes to be publicly available, as public availability--
at no cost--should assure wide dissemination of ratings and provide the 
opportunity for the marketplace to judge the credibility and 
reliability of an entity's credit ratings.
---------------------------------------------------------------------------

    \59\ See, e.g., Letter from Yasuhiro Harada, Executive Vice 
President, Rating and Investment Information, Inc., to Jonathan G. 
Katz, Secretary, Commission (July 28, 2003).
    \60\ See, e.g., Letter from David Colling, Product Director, ABS 
Reports (UK) Limited), to Jonathan G. Katz, Secretary, Commission 
(July 31, 2003).
    \61\ See, e.g., Letter from James A. Kaitz, President and CEO, 
Association for Financial Professionals, to Jonathan G. Katz, 
Secretary, Commission (July 28, 2003).
    \62\ Id.
    \63\ See, e.g., Letter from Richard Raeburn, Chief Executive, 
and John Grout, Technical Director, The Association of Corporate 
Treasurers, United Kingdom, to Jonathan G. Katz, Secretary, 
Commission (August 8, 2003).
---------------------------------------------------------------------------

    This approach is consistent with the views of most commenters 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. The Commission notes that in proposing to define 
the term ``NRSRO'' as an entity that makes its credit ratings publicly 
available, the public availability reference only would apply to the 
credit rating itself (i.e., the rating symbol), and not to other 
information otherwise developed by the credit rating agency (e.g., the 
credit rating agency's rating rationale). This approach should not 
result in NRSROs charging higher fees for their services because it 
would not require a credit rating agency to make available at no cost 
the analysis underlying its rating.\64\ The Commission notes that this 
approach is also consistent with the current practices of many credit 
rating agencies, including each of the current NRSROs, that already 
publish their credit ratings on a widespread basis at no cost.
---------------------------------------------------------------------------

    \64\ In connection with the Commission's review of issues 
concerning credit rating agencies, commenters have consistently 
represented that they typically subscribe to a rating agency's 
services primarily to understand the analysis underlying the rating 
agency's ratings--not solely for the credit rating itself. For 
example, during the Commission's 2002 credit rating agency hearings, 
representatives of users of credit ratings (e.g., from mutual fund 
companies and broker-dealers) indicated that they review research 
that is done by credit rating agencies to assess credit risk for the 
securities they purchase within their portfolios. See, e.g., SEC 
Hearing Transcript, supra note 30 (November 15, 2002) (testimony of 
Deborah A. Cunningham, Senior Vice President and Senior Portfolio 
Manager, Federated Investors, Inc., and testimony of Cynthia L. 
Strauss, Director of Taxable Bond Research, Fidelity Investments 
Money Management, Inc.).
---------------------------------------------------------------------------

    Questions: How should it be determined whether an NRSRO is making 
its credit ratings readily available on a widespread basis? Should our 
rule specify the manner and methods that must be used to distribute 
ratings? Should internet posting itself be sufficient?
b. Issue-Specific Credit Opinions
    The Commission is aware that credit rating agencies often issue 
different types of credit ratings that can reflect, among other things, 
the creditworthiness of specific securities or obligations, or the 
general creditworthiness of specific entities. Because the Commission's 
regulatory use of the term ``NRSRO'' primarily relates to credit 
ratings on specific securities or obligations, the Commission, in its 
proposed definition of the term ``NRSRO,'' is limiting the availability 
of the NRSRO concept to entities that issue such ratings.
    The Commission is proposing to clarify this element of the proposed 
NRSRO definition because credit rating agencies that do not issue 
credit ratings on specific securities, but instead issue credit ratings 
on the general creditworthiness of specific entities, have requested 
NRSRO no-action relief. The risk of loss on different debt instruments 
of the same issuer can vary considerably depending on the terms written 
into a security's legal documentation. Therefore, applying a single 
``issuer'' rating to all of an issuer's outstanding debt instruments 
could be misleading, in the context of the regulatory use of NRSRO 
ratings, and have adverse regulatory implications.
    Questions: Should a credit rating agency that does not rate 
specific securities or money market instruments be included in the 
definition of NRSRO? If so, under what circumstances?
c. Current Credit Opinions
    The proposed definition also attempts to ensure that only 
``current'' credit ratings--meaning that such ratings are actively 
monitored and updated appropriately on a continuous basis--be used for 
regulatory purposes under the federal securities laws. The Commission 
believes that credit ratings used for regulatory purposes should be 
actively monitored on a continuous basis and confirmed, upgraded, or 
downgraded, if and when necessary. The Commission's reliance on credit 
ratings from a credit rating agency that are not current, and thus, may 
not even reflect the credit rating agency's own view as to the 
creditworthiness of a security, could interfere with the intended 
regulatory uses of the NRSRO rating.
    The first component of the proposed definition would require a 
credit rating agency to issue credit ratings that are ``current 
assessments'' of the creditworthiness of specific securities or money 
market instruments. This component may help to ensure that persons 
relying on a rating for regulatory purposes in Commission rules and 
regulations can have confidence, at any given time, that the rating 
reflects the credit rating agency's current view.
    Under the proposed definition, the Commission would interpret 
``current assessments'' to mean that a credit rating agency's published 
credit ratings reflect its opinion as to the creditworthiness of a 
security or money

[[Page 21312]]

market instrument as of the time the rating was issued and until the 
rating is changed or withdrawn. Under this interpretation, a credit 
rating agency could meet the ``current assessments'' element of the 
proposed definition if it has and follows procedures designed to ensure 
that its ratings are reviewed and, if necessary, updated on the 
occurrence of material events, including significant sector or issue-
specific events. By including in the NRSRO definition that a credit 
rating agency's ratings need to be ``current assessments,'' the 
Commission is responding to comments received in response to the 2003 
Concept Release that a requirement that NRSRO ratings be kept 
``current'' is desirable.\65\
---------------------------------------------------------------------------

    \65\ See, e.g., supra note 63.
---------------------------------------------------------------------------

    Further, although the Commission is proposing to define the term 
``NRSRO'' to require an NRSRO's ratings to be current, the Commission 
is not proposing to prescribe a specific time period within which an 
NRSRO's ratings would need to be updated. Specifying a time period 
within which a credit rating agency must update or affirm a rating 
might be problematic because the appropriate time period for responding 
to a material event may vary considerably based on, for example, the 
complexity of an issuer or the specific security being rated. 
Accordingly, it may be appropriate for a credit rating agency to have 
the flexibility to respond to material events relating to its ratings 
on a case-by-case basis. This approach responds to comments that the 
Commission should not set detailed standards as to when a rating agency 
should update its ratings.\66\
---------------------------------------------------------------------------

    \66\ See, e.g., supra note 59.
---------------------------------------------------------------------------

    Questions: Should the Commission provide additional interpretation 
regarding what it means for a credit rating agency's credit ratings to 
be ``current assessments''? Should the Commission specify the time 
period? Will the proposed rule's provisions provide sufficient 
assurance to the markets that ratings are current?
2. The Second Component
a. General Acceptance in the Financial Markets
    As discussed above, the notion that a credit rating agency be 
``nationally recognized'' for purposes of the NRSRO concept was 
designed to ensure that credit ratings used for regulatory purposes are 
credible and reliable, and are reasonably relied upon by the 
marketplace. Responding to most commenters to the 2003 Concept Release 
that NRSRO status should be based primarily on a credit rating agency's 
wide acceptance in the marketplace, the second proposed component of 
the ``NRSRO'' definition focuses on whether a credit rating agency is 
generally accepted in the financial markets as an issuer of credible 
and reliable ratings by the predominant users of securities ratings.
    The Commission is proposing that the second component of the NRSRO 
definition require a credit rating agency to be generally accepted in 
the financial markets. Such acceptance would reflect the markets' 
belief in the credibility and reliability of the ratings provided by 
the credit rating agency and should provide some level of assurance to 
those relying on ratings with regard to the dependability and 
consistency of the ratings for a variety of regulatory purposes. For 
example, net capital calculations and haircuts that are determined 
through use of these credit ratings are more likely to be reliable than 
those determined without the use of such ratings and, thus, could be 
more likely to protect customers and other market participants from 
harm in the event of a broker-dealer failure.
    Further, linking the evaluation of a credit rating agency's ratings 
to the views of the predominant users of securities ratings would be 
helpful. Predominant users generally include financial market 
participants who hold large inventories of proprietary debt securities, 
preferred stock, and commercial paper, such as broker-dealers, mutual 
funds, pension funds, and insurance companies. These firms--given their 
large inventories of rated fixed income securities--generally have 
developed sophisticated internal credit rating departments which rate 
issuers and counterparties. However, they also rely on external ratings 
from credit rating agencies to compare against and test their internal 
rating and analysis. Given the importance of credit ratings to the 
business of these market participants, and to the stability of the 
financial markets as a whole, the Commission believes that 
incorporating their views into the definition of NRSRO provides a 
certain level of credibility and reliability to NRSRO ratings.
    The Commission proposes that a credit rating agency could meet the 
second component of the NRSRO definition through a variety of objective 
means. For example, in appropriate circumstances, a credit rating 
agency could do so through statistical data that demonstrates market 
reliance on the credit rating agency's ratings (e.g., market movements 
in response to ratings changes). A credit rating agency also might be 
able to satisfy the second component if authorized officers of users of 
securities ratings representing a substantial percentage of the 
relevant market attest that the credit rating agency's ratings are 
credible and actually relied on by the users.
    Questions: How else could the Commission define the term ``NRSRO'' 
in order for users of a credit rating agency's ratings to determine 
whether such ratings are credible and are reasonably relied upon by the 
marketplace? Are the approaches discussed above useful for determining 
whether a credit rating agency meets the second component of the 
proposed definition? Are there other types of information that would be 
appropriate? For example, should the fact that a credit rating agency 
has many subscribers support a finding that the credit rating agency 
satisfies the second component? What types of statistical data could be 
relied on to determine if a credit rating agency's credit ratings are 
relied on by the marketplace? What standards should be considered to 
assess such statistical data? Should the views of issuers be a relevant 
consideration in determining whether a credit rating agency meets the 
second component of the NRSRO definition?
b. Limited Coverage NRSROs
    Commenters at both the Commission's credit rating agency hearings 
and responding to the 2003 Concept Release generally supported the idea 
that the definition of the term ``NRSRO'' could include credit rating 
agencies that confine their activities to limited sectors of the debt 
market or to limited (or largely non-U.S.) geographic areas. While 
several commenters suggested that the Commission distinguish between 
full- and limited-coverage NRSROs,\67\ others represented that credit 
rating agencies should only be able to meet the definition as full-
coverage NRSROs because, in their view, it would be difficult for 
limited coverage NRSROs to provide a full and accurate assessment of 
credit risks without a broader expertise in credit risk assessment.\68\
---------------------------------------------------------------------------

    \67\ Id.
    \68\ See, e.g., Letter from Jonathan C. Conley, Federated 
Investment Management Company, to Jonathan G. Katz, Secretary, 
Commission (July 28, 2003).
---------------------------------------------------------------------------

    Based on the staff's experience in issuing no-action letters to 
credit rating agencies, a credit rating agency that has developed a 
general acceptance in the financial markets for a limited sector of the 
debt market or a limited geographic area could meet the NRSRO 
definition. As noted in Section II.B., NRSRO no-action letters have 
been provided to

[[Page 21313]]

such firms in the past. In these instances, even though the credit 
rating agencies were generally accepted in the financial markets for a 
limited sector of the debt market or a limited geographic area, their 
market acceptance was based on the credibility and reliably of their 
ratings. Accordingly, the regulatory use of those ratings in Commission 
rules and regulations was appropriate and consistent with the purposes 
underlying the NRSRO concept.
    Questions: Should a credit rating agency that is recognized by the 
financial marketplace for issuing credible and reliable ratings within 
a limited sector or geographic area meet the NRSRO definition only for 
its ratings within such sector or geographic area, or more broadly? If 
a credit rating agency meets the NRSRO definition only with respect to 
its ratings within a particular sector or geographic area, would the 
NRSRO classification interfere with the credit rating agency's ability 
to expand its business? How should ratings from such an NRSRO be 
identified so that broker-dealers and other users of NRSRO ratings for 
regulatory purposes can determine which credit ratings from the NRSRO 
may be used for regulatory purposes? We noted above that commenters 
mentioned that it would be difficult for limited coverage NRSROs to 
provide a full and accurate assessment of credit risks without a 
broader expertise in credit risk assessment. We request further comment 
on this view given our proposal to permit limited coverage NRSROs.
3. The Third Component
    The third proposed component of the NRSRO definition is designed to 
ensure that to meet the definition of the term ``NRSRO,'' a credit 
rating agency uses systematic procedures designed to ensure credible 
and reliable ratings, manage conflicts of interest, and prevent the 
misuse of nonpublic information. It also addresses the need for credit 
rating agencies to have sufficient financial resources to ensure 
compliance with such procedures, if they are to meet the definition.
    The Commission preliminarily believes that including in the 
proposed definition the requirement that an entity use systematic 
rating procedures in producing credit ratings should help to ensure 
that NRSRO ratings are based on a thorough credit analysis of issuers 
and their financial obligations. This type of analysis should, in turn, 
assist the credit rating agency in producing credible and reliable 
ratings, which as discussed above, would further the purposes 
underlying the regulatory uses of NRSRO ratings.
    The Commission preliminarily believes that the following would be 
important for assessing whether a credit rating agency meets the third 
component of the proposed definition: (i) The experience and training 
of a firm's rating analysts (pertaining to the analysts' ability to 
understand and analyze relevant information); (ii) the average number 
of issues covered by analysts (relevant to whether analysts are capable 
of continuously monitoring and assessing relevant developments relating 
to their ratings); (iii) the information sources reviewed and relied 
upon by the credit rating agency and how the integrity of information 
utilized in the ratings process is verified (relating to the extent and 
quality of information upon which a firm's ratings are based); (iv) the 
extent of contacts with the management of issuers, including access to 
senior level management and other appropriate parties (pertaining to, 
among other things, the quality and credibility of an issuer's 
management and to attempt to better understand the issuer's financial 
and operational condition); (v) the organizational structure of the 
credit rating agency (to demonstrate, among other things, the firm's 
independence from the companies it rates and from potential conflicts 
of interest that may result from related businesses or those of an 
affiliate); (vi) how the credit rating agency identifies and manages or 
proscribes conflicts of interest affecting its ratings business; (vii) 
how the credit rating agency monitors and enforces compliance with its 
procedures designed to prohibit the misuse of material, nonpublic 
information; and (viii) the financial resources of the credit rating 
agency (regarding whether, among other things, a credit rating agency 
has sufficient financial resources to ensure that it maintains 
appropriate staffing levels to continuously monitor the issuers whose 
securities it rates and to operate independently of economic pressures 
or control from the companies it rates and from subscribers).
a. Analyst Experience and Training
    There was no consensus among commenters to the 2003 Concept Release 
as to whether the experience and training of a credit rating agency's 
staff should be a factor in determining whether a credit rating agency 
is an NRSRO. Similarly, there was no consensus as to whether the 
Commission should include in an NRSRO definition minimum standards for 
the training and qualifications of the credit rating agency's credit 
analysts.
    Several commenters indicated that the competency of a credit rating 
agency's staff should be a relevant consideration in connection with 
being an NRSRO, and that experience and training of a credit rating 
agency's staff are of particular importance.\69\ Several commenters 
suggested that, to be an NRSRO, a credit rating agency should develop 
minimum standards for training and qualification of its analysts, and 
that compliance with such standards should be verified when assessing 
whether a credit rating agency is an NRSRO.\70\ There was also support 
among commenters that an NRSRO should take steps to verify whether 
members of its staff have been subject to disciplinary action by a 
financial (or other) regulatory authority.\71\
---------------------------------------------------------------------------

    \69\ See, e.g., Letter from Mark Roemer, Finance Strategies, 
Siemens AG, to Commission (July 28, 2003).
    \70\ See, e.g., Letter from William M. Wells, Chief Financial 
Officer, Bunge Limited, to Commission (July 28, 2003).
    \71\ See, e.g., Letter from Joseph E. Cantwell, President, 
Cantwell & Company, to Commission (July 22, 2003).
---------------------------------------------------------------------------

    While several commenters were of the view that minimum training 
standards for NRSROs would be appropriate, a few indicated that 
oversight of training methods would add little value to the NRSRO 
concept.\72\ One commenter recommended that NRSROs should be required 
to disclose staff qualifications and staff size on a periodic 
basis.\73\ Several commenters also represented that credit rating 
agencies with staffing deemed inadequate by the marketplace would 
quickly be rejected by investors and issuers.\74\
---------------------------------------------------------------------------

    \72\ Id.
    \73\ See, e.g., Letter from Cate Long, Multiple-Markets, to 
Commission (July 28, 2003).
    \74\ See, e.g., supra note 61.
---------------------------------------------------------------------------

    The Commission is not proposing to require that a credit rating 
agency satisfy specified minimum experience and training requirements 
to meet the proposed definition of the term ``NRSRO.'' A credit rating 
agency with an inadequately trained and inexperienced staff would 
likely encounter difficulties meeting the second and third components 
of the proposed definition. However, the Commission currently believes 
that to meet the proposed definition of the term ``NRSRO,'' a credit 
rating agency should have procedures designed to ensure that its 
analysts are competent--that is, that they are able to identify, 
understand, and analyze information relevant to the issuers whose 
securities they rate. A credit rating agency should also have 
procedures designed to examine the backgrounds of its analysts and 
other members of its staff.

[[Page 21314]]

    The Commission believes that analyst experience and training is an 
important consideration with regard to the NRSRO concept because credit 
ratings relied upon by the marketplace typically result from thorough 
and competent credit analysis employed by a credit rating agency's 
analysts. For example, if a credit rating agency's rating procedures 
require an analyst to evaluate an issuer's financial statements, the 
ability of the analyst to understand and analyze those financial 
statements depends on the analyst's experience and training in 
financial analysis. If the credit rating agency's rating procedures do 
not require such experience and training, it follows that the credit 
rating agency would not have systematic procedures designed to ensure 
credible and reliable ratings, and that it would be inappropriate to 
rely on the credit rating agency's ratings for providing limited 
exemptions or privileges in Commission rules.
    While the Commission is not proposing to require NRSROs to disclose 
staff qualifications and size on a periodic basis, as suggested by 
commenters, such disclosures on a voluntary basis could assist users of 
a credit rating agency's ratings in assessing whether the credit rating 
agency uses systematic procedures designed to ensure credible and 
reliable ratings.
    Questions: The Commission recognizes that the evaluation of an 
analyst's experience would involve a degree of subjectivity. The 
Commission requests comment on the appropriate subjective criteria that 
a credit rating agency should use in assessing the experience and 
training of an analyst to meet the proposed NRSRO definition. In 
addition, what objective criteria are relevant? What level of 
importance should be given to the subjective and objective criteria? 
How can a credit rating agency in seeking to meet the proposed NRSRO 
definition demonstrate that it has adequate procedures designed to 
ensure that its analysts are competent? What factors should a credit 
rating agency consider in evaluating the background of its analysts and 
other members of its staff?
b. Number of Ratings Per Analyst
    While there was little support for the Commission to condition 
NRSRO status on an entity's meeting standards for a maximum average 
number of issues covered per analyst, there was support for requiring 
NRSROs to disclose the number of credit analysts they employ and the 
average number of issues rated or otherwise followed by those 
analysts.\75\
---------------------------------------------------------------------------

    \75\ See, e.g., supra note 73.
---------------------------------------------------------------------------

    Commenters generally shared the view that the number of analysts 
and number of issues rated per analyst are best left to the credit 
rating agencies.\76\ They also generally agreed that strong incentives 
exist for credit rating agencies to monitor the quality of their 
analysis due to the constant scrutiny from both issuers and 
investors.\77\ Further, they agreed that analysts must maintain 
reasonable workloads for their analytical quality to remain high.\78\ 
Concern was also expressed that setting such standards would involve 
the Commission too deeply into the business practices of credit rating 
agencies and that they could potentially create barriers to NRSRO 
status.\79\
---------------------------------------------------------------------------

    \76\ See, e.g., supra note 70.
    \77\ Id.
    \78\ See, e.g., supra note 71.
    \79\ See, e.g., supra note 40.
---------------------------------------------------------------------------

    Based on the views of commenters, the Commission is not proposing 
that a credit rating agency must have specific limits on the number of 
securities rated per analyst to meet the definition of the term 
``NRSRO.'' However, as a preliminary matter, the Commission is 
concerned that a credit rating agency's ratings may become less 
reliable as the number of issues rated per analyst increases. This 
appears more significant to the extent an analyst rates securities of 
issuers with complex business models operating in a variety of 
industries.
    Due to this concern, and the Commission's preliminary belief that 
credit ratings used for regulatory purposes should be the result of a 
competent and thorough analysis, a credit rating agency should be able 
to demonstrate to users of its securities ratings that its analysts are 
capable of continuously monitoring and assessing relevant developments 
relating to their ratings. Thus, the number of ratings per analyst 
could be an important consideration for users of securities ratings in 
assessing under the third component of the proposed definition whether 
a credit rating agency uses systematic procedures designed to ensure 
credible and reliable ratings.
    While the Commission is not proposing to require credit rating 
agencies to disclose the number of credit analysts they employ and the 
average number of issues rated or otherwise followed by those analysts, 
as suggested by commenters, it may be that disclosures such as these 
would assist users of a credit rating agency's ratings in assessing 
whether the credit rating agency uses systematic procedures designed to 
ensure credible and reliable ratings.
    Questions: Is the concern that a credit rating agency's ratings may 
become less reliable as the number of issues rated per analyst increase 
valid? If so, what type of workload is reasonable for the analytical 
quality of a credit rating agency's ratings to remain high? Should the 
Commission specify minimum standards for a credit rating agency's 
analysts to continuously monitor and assess relevant developments 
relating to their ratings so that users of the credit rating agency's 
ratings can determine whether the credit rating agency meets the NRSRO 
definition? If a credit rating agency relies primarily on quantitative 
models to develop credit ratings, how can such a firm's ratings reflect 
a thorough analysis of the specific credit characteristics of a 
particular security? Should the Commission require credit rating 
agencies to disclose the number of credit analysts they employ and the 
average number of issues rated or otherwise followed by those analysts, 
as suggested by commenters?
c. Information Sources Used in the Ratings Process
    The process of rating a particular issuer's securities typically 
begins with collecting relevant financial information about the issuer. 
Relevant financial information often includes an issuer's recent past 
financial performance and current financial condition. This information 
generally is obtained directly from the issuer in the form of audited 
and unaudited financial statements. In some instances, credit rating 
agencies rely on third parties that collect the information and 
disseminate it through proprietary data feeds. Generally, these vendors 
download or otherwise obtain public financial information (e.g., from 
10-K's and 10-Q's) and repackage such information into data feeds to 
subscribers.
    The reliability of a credit rating agency's ratings depends, in 
part, on the integrity of the information upon which the credit rating 
agency bases its ratings. Therefore, the Commission believes that, to 
meet the third component of the NRSRO definition, credit rating 
agencies should have controls in place to reasonably assess the 
integrity of the information sources they rely on in their ratings 
process.\80\ For example, if a credit rating agency is relying on 
quantitative financial results, such as an issuer's quarterly earnings, 
provided by

[[Page 21315]]

a third-party vendor, the credit rating agency should have a process 
designed to test the integrity of the vendor's information. This could 
include cross-checking a sample of the earnings reports against other 
sources such as audit reports, Commission filings (e.g., a 10-K or 10-
Q), or by contacting the issuer.
---------------------------------------------------------------------------

    \80\ We do not intend here to suggest that a credit rating 
agency must audit or otherwise ensure the accuracy of an issuer's 
financial condition.
---------------------------------------------------------------------------

    Questions: Should a credit rating agency be required to test in 
some way the integrity of information provided directly by issuers 
(both public and nonpublic) and through third party vendors? Are there 
other appropriate objective methods for determining whether a credit 
rating agency has reasonably tested the integrity of the information on 
which it bases its ratings?
d. Contacts With Management
    In the 2003 Concept Release, the Commission inquired whether it 
should limit the credit ratings that can be used for regulatory 
purposes in Commission rules to credit rating agencies that regularly 
contact senior management of an issuer. A number of commenters 
indicated that obtaining senior management's views enhances a credit 
rating agency's ability to assess the quality and credibility of an 
issuer's management and to attempt to better understand the issuer's 
operational and financial condition.\81\ Others, however, indicated 
that it is possible to perform a high quality credit analysis when 
sufficient publicly available information exists on an issuer.\82\ It 
was noted by commenters that requiring contact with issuer management 
could act as a barrier to entry for smaller credit rating agencies that 
cannot compel issuers to engage in a dialogue.\83\ Other commenters 
indicated that issuer management would be less inclined to talk to 
credit rating agencies issuing lower ratings.\84\
---------------------------------------------------------------------------

    \81\ See, e.g., supra note 69.
    \82\ See, e.g., supra note 40.
    \83\ See, e.g., Letter from LACE Financial Corp. (July 25, 
2003).
    \84\ See, e.g., Letter from Sean J. Egan, Managing Director, 
Egan-Joens Ratings Co., to Jonathan G. Katz, Secretary, SEC (July 
28, 2003).
---------------------------------------------------------------------------

    The Commission's proposed definition of the term ``NRSRO'' does not 
explicitly limit the definition of the term ``NRSRO'' to entities that 
systematically contact an issuer's senior management. Nonetheless, it 
could be important for a credit rating agency whose credit ratings will 
be used for regulatory purposes to involve in the rating process, when 
possible, an issuer's senior management, or, in the case of issuers of 
asset-backed securities, other appropriate parties.\85\
---------------------------------------------------------------------------

    \85\ For instance, we would expect ratings on securities issued 
by asset-backed issuers to involve, as appropriate, the senior 
personnel of their depositor and servicer.
---------------------------------------------------------------------------

    Question: In designing and implementing systematic procedures to 
ensure credible and reliable ratings, should a credit rating agency 
seeking to meet the definition of NRSRO address how and the extent to 
which it involves an issuer's senior management in the rating process? 
To meet the proposed NRSRO definition, should a credit rating agency's 
procedures require that the credit rating agency request an issuer's 
senior management to participate in the credit rating agency's rating 
process without incurring a fee?
e. Organizational Structure
    Commenters generally agreed that organizational structure is an 
appropriate factor to consider when evaluating whether a rating agency 
is an NRSRO. Commenters indicated that credit rating agencies typically 
structure their businesses to ensure that their ratings have been 
thoroughly analyzed, reviewed, and approved by independent and relevant 
persons within a credit rating agency's organization, and that because 
of this, it would be appropriate to consider a credit rating agency's 
organizational structure when evaluating a credit rating agency's 
status as an NRSRO.\86\ Several commenters also believed that this 
would enable the Commission to better identify and potentially minimize 
conflicts of interest issues at NRSROs.\87\
---------------------------------------------------------------------------

    \86\ See, e.g., supra note 41.
    \87\ See, e.g., Letter from Olivier Raingeard, to Commission 
(July 27, 2003).
---------------------------------------------------------------------------

    Some commenters believed that NRSROs should consent to limiting 
their business to issuing credit ratings because it would be useful to 
prevent NRSROs from engaging in activities that raise conflicts of 
interest issues.\88\ Others disagreed, however, indicating that it is 
not necessary or in investors' best interests to preclude an NRSRO from 
being part of a larger business organization that has the ability to 
offer financial strength and stability and can support the level of 
investment necessary to continually enhance their ratings 
operations.\89\
---------------------------------------------------------------------------

    \88\ See, e.g., Letter from Takashi Kanasaki, Managing Director, 
Japan Credit Rating Agency, Ltd., to Jonathan G. Katz, Secretary, 
Commission (July 14, 2003).
    \89\ See, e.g., supra note 40.
---------------------------------------------------------------------------

    For the reasons discussed above, the Commission preliminarily 
believes that a credit rating agency's organizational structure would 
be relevant to determine whether the credit rating agency meets the 
definition of NRSRO. For example, such structure should include a 
process for ensuring that credit ratings are analyzed, reviewed, and 
approved at all appropriate levels within the credit rating agency's 
organizational structure. Further, the organizational structure of a 
credit rating agency can also be designed to avoid or minimize 
potential conflicts of interest and prevent the misuse of nonpublic 
information (e.g., through firewalls separating ratings services and 
analysts from affiliated businesses).
    Though the Commission is not defining the term ``NRSRO'' to exclude 
a credit rating agency from being part of a larger business 
organization, certain affiliated businesses of a credit rating agency 
could interfere with the credit rating agency's ability to meet the 
proposed NRSRO definition. For example, a credit rating agency that is 
affiliated with an entity that underwrites securities rated by the 
credit rating agency would have a difficult time meeting the third 
component regarding procedures to manage conflicts of interest.
    Questions: Would information on a credit rating agency's 
organizational structure be useful to users of ratings? If so, what 
information would be useful?
f. Conflicts of Interest
    Conflicts of interest may arise in a number of areas within a 
credit rating agency. For example, commenters to the 2003 Concept 
Release indicated that reliance on issuer fees by a credit rating 
agency could lead to conflicts of interest and the potential for rating 
inflation.\90\ Commenters also represented that conflicts of interest 
can arise when credit rating agencies offer consulting or other 
advisory services to the entities they rate.\91\ In addition, during 
the Commission's 2002 credit rating agency hearings, hearing 
participants indicated that a credit rating agency's subscribers could 
be given preferential access to rating analysts and, as a result, 
inappropriately may learn of potential rating actions or other 
nonpublic information. The Commission notes that conflicts may arise as 
well when a person associated with a credit rating agency (e.g., an 
employee) also is associated with or has an interest in an issuer that 
is being rated.
---------------------------------------------------------------------------

    \90\ See, e.g., supra note 84.
    \91\ Id.
---------------------------------------------------------------------------

    As noted above, investors rely on credit ratings directly and 
through investor protection regulation that uses the NRSRO concept. 
Given this reliance, an investor could be harmed if a rating is unduly 
influenced by a person with

[[Page 21316]]

a vested interest in the level of the rating.
    In responding to the 2003 Concept Release, most commenters 
supported the idea of conditioning NRSRO status on a credit rating 
agency implementing procedures to address conflicts of interest in its 
business.\92\ We believe that concerns about conflicts of interest are 
valid and have therefore proposed, as part of the definition of the 
term ``NRSRO,'' that an entity must use systematic procedures designed 
to manage potential conflicts of interest. To satisfy this part of the 
definition, a credit rating agency should, at a minimum, be able to 
identify the types of conflicts of interest that arise in its business, 
its procedures designed to address and minimize or avoid those 
conflicts of interest, and how the firm monitors and verifies 
compliance with those procedures. The Commission believes that it is 
necessary for an NRSRO to take these steps to address conflicts of 
interest because credit ratings may be unduly influenced by obligors, 
subscribers, or other interested persons if conflicts of interest are 
not handled appropriately.
---------------------------------------------------------------------------

    \92\ See, e.g., Letter from Charles D. Brown, General Counsel, 
Fitch Ratings, to Jonathan G. Katz, Secretary, SEC (July 28, 2003).
---------------------------------------------------------------------------

    Further, if a credit rating agency has adopted procedures to 
address conflicts arising, for example, between its ratings business 
and its affiliated advisory business, then such procedures, if 
followed, would reduce the risk that obligors will be unduly pressured 
into purchasing advisory services in order to maintain their credit 
rating.\93\ Questions: What specific conflicts of interest should be 
addressed in a credit rating agency's procedures and how should they be 
addressed? Should a credit rating agency that engages in activities 
that present potential or actual conflicts of interest be excluded from 
the definition of NRSRO? Alternatively, is it sufficient for a credit 
rating agency to impose and implement safeguards to prevent potential 
conflicts of interest from affecting the quality and independence of 
its credit ratings? Are there other practices that raise concerns 
similar to those raised by conflicts of interest, for example, those 
referred to in footnote 93 regarding unsolicited ratings, that should 
be addressed in a credit rating agency's procedures?
---------------------------------------------------------------------------

    \93\ A separate area of concern arises when credit rating 
agencies issue unsolicited ratings. These are ratings that are not 
initiated at the request of the issuer. Specifically, one concern 
with unsolicited ratings is that they will be used by a credit 
rating agency to obtain business from issuers. For example, a credit 
rating agency could conceivably issue an unsolicited rating and send 
it to the issuer along with a fee schedule for its rating services. 
See, e.g., Letter from James I. Kaplan, Associate General Counsel, 
Northern Trust Corporation, to Jonathan G. Katz, Secretary, 
Commission (July 28, 2003). Moreover, the rating agency improperly 
might issue a lower than warranted rating in order to increase the 
issuer's incentive to purchase the rating service. We believe that 
unsolicited ratings raise sufficient concerns such that a credit 
rating agency should have procedures designed to avoid employing 
improper practices with respect to unsolicited ratings and to 
monitor and verify compliance with those procedures.
---------------------------------------------------------------------------

g. Misuse of Information
    Some credit rating agencies, as part of their analysis, maintain 
contact with senior management of the issuers they rate. In the course 
of these contacts, an issuer may provide an analyst with nonpublic 
information such as contemplated business transactions or estimated 
financial information. There is a potential that this information could 
be used by a credit rating analyst or others for improper purposes. In 
fact, the Commission recently brought an insider trading action against 
a former analyst of a credit rating agency.\94\ The Commission, in that 
case, alleged that the analyst obtained information about two proposed 
transactions and tipped that information to others.\95\
---------------------------------------------------------------------------

    \94\ Commission v. Rick A. Marano, William Marano and Carl 
Loizzi, Civil Action No. 04 CV 5828 (Judge Kimba Wood) (S.D.N.Y. 
July 27, 2004), available on the SEC Web site at http://www.sec.gov/litigation/litreleases/lr18799.htm.
    \95\ Id.
---------------------------------------------------------------------------

    As this example shows, there is the risk that persons exposed to 
such material, nonpublic information may trade on it. In fact, the 
Commission staff, as part of its 2002 NRSRO examinations discussed 
above in Section II, identified as a potential concern, among other 
things, the effectiveness of the NRSROs' existing policies and 
procedures designed to protect confidential information.\96\ In light 
of this concern, the Commission posed a number of questions in the 2003 
Concept Release to solicit comment on the protection of nonpublic 
information. For example, the Commission asked whether NRSRO 
recognition should be conditioned on a credit rating agency having 
internal procedures to prevent the misuse of nonpublic information.\97\ 
Commenters generally acknowledged the importance of protecting 
nonpublic information provided by issuers.\98\ They explained that 
nonpublic information greatly assists credit rating agencies in issuing 
credible and reliable ratings and pointed out that if credit rating 
agencies had a track record of failing to protect such information, 
issuers would stop providing such information.\99\
---------------------------------------------------------------------------

    \96\ See supra note 28.
    \97\ See supra note 1.
    \98\ See, e.g., supra note 59.
    \99\ See, e.g., supra note 40.
---------------------------------------------------------------------------

    The Commission believes that for a credit rating agency to meet the 
proposed definition of the term ``NRSRO,'' it should have policies and 
procedures that are designed to effectively protect nonpublic 
information provided by issuers. Accordingly, under the third component 
of the proposed NRSRO definition, a credit rating agency would be 
required to adopt and implement procedures designed to prohibit the 
misuse of material, nonpublic information obtained during the credit 
rating process. The Commission believes that to meet this component of 
the NRSRO definition, a credit rating agency should adopt procedures 
governing the receipt and use of nonpublic information that applies to 
all employees.
    Question: As discussed above, to meet the third component of the 
NRSRO definition, should a credit rating agency demonstrate that it has 
systematic procedures designed to prevent the misuse of material 
nonpublic information? What types of procedures are reasonable for a 
credit rating agency to protect material nonpublic information? Should 
a credit rating agency have personnel dedicated specifically to 
verifying employees' compliance with such procedures? Should persons 
performing this function provide ongoing training of employees and act 
as a resource to answer questions as they arise? Should the procedures 
provide for a system by which employees can report violations of the 
controls in place to protect nonpublic information or other 
inappropriate activities? The Commission encourages commenters to 
provide information on appropriate procedures for receiving and 
adequately securing material nonpublic information.
h. Financial Resources
    There was no consensus among commenters to the 2003 Concept Release 
as to whether a credit rating agency's financial resources should be 
considered by the Commission as a condition for NRSRO recognition. 
Several commenters supported the evaluation of a credit rating agency's 
financial resources as a condition, particularly to ensure that NRSROs 
maintain financial independence from rated issuers and 
subscribers.\100\ One commenter suggested that such a

[[Page 21317]]

condition be used to ensure that an NRSRO does not receive more than a 
small portion of revenue from any particular issuer or customer,\101\ 
and another suggested that NRSROs be required to disclose information 
relating to their financial resources.\102\ One commenter also stated 
that it would be prejudicial to investors if securities they purchased, 
based in part on credit ratings, ceased to be rated because the credit 
rating agencies that rated them no longer existed.\103\
---------------------------------------------------------------------------

    \100\ See, e.g., Letter from Walter Schroeder, President, 
Dominion Bond Rating Service Limited, to Jonathan G. Katz, 
Secretary, Commission (August 5, 2003).
    \101\ See, e.g., supra note 63.
    \102\ See, e.g., supra note 73.
    \103\ See, e.g., supra note 70.
---------------------------------------------------------------------------

    Commenters that opposed the use of financial resources as an NRSRO 
criterion generally represented that meeting a mandated level of 
capital or financial resources does not assure the credibility or 
reliability of a credit rating agency's ratings and, accordingly, the 
Commission should instead focus on such credibility and 
reliability.\104\
---------------------------------------------------------------------------

    \104\ See, e.g., supra note 87.
---------------------------------------------------------------------------

    The Commission is not proposing to specify minimum financial 
requirements as part of the definition of the term ``NRSRO.'' The 
Commission anticipates that the financial resources necessary to 
support an NRSRO would vary based on the size and scope of the credit 
rating agency's business. The Commission has proposed, however, that in 
order for a credit rating agency to meet the definition of the term 
``NRSRO,'' it would be required to have sufficient financial resources 
to ensure that it is able to comply with its procedures. For example, 
to meet the definition, a credit rating agency would need to have 
sufficient financial resources to ensure that it maintains appropriate 
staffing levels to continuously monitor the issuers it rates. Further, 
a credit rating agency with sufficient financial resources is less 
likely to be subject to conflicts of interest as described above 
because of its financial independence from subscribers and issuers it 
rates.
    Questions: Should a credit rating agency make its audited financial 
statements readily available to users of securities ratings in order 
for such users to assess whether a credit rating agency has sufficient 
financial resources to satisfy the third component? What other types of 
financial information could a credit rating agency make available to 
users of securities ratings for purposes of the third component? Should 
a credit rating agency provide users of securities ratings with 
information relating to the percentage of revenue it receives from 
particular issuers or subscribers as compared to the credit rating 
agency's total revenues? Should a credit rating agency establish 
procedures to limit the percentage of revenues it receives from a 
single issuer or subscriber? How else can it be determined that a 
credit rating agency is financially independent of both subscribers and 
rated issuers?
i. Standardized Rating Symbols
    Several commenters responded to the Commission's request on whether 
NRSROs should use uniform rating symbols to reduce the risk of 
marketplace confusion. Commenters generally supported the idea of 
uniform rating symbols by NRSROs, indicating that such standardization 
would be particularly helpful if the number of NRSROs increase.\105\ 
However, one credit rating agency indicated that mandated uniformity of 
rating symbols could mislead investors into assuming that all NRSRO 
credit ratings are comparable and involve the same analytical 
judgments, ratings criteria, and methodologies.\106\ Another commenter 
suggested that rather than establish uniform rating symbols, the 
Commission should require each NRSRO to annually disclose the 
definition and historic default rates for the rating symbols it 
uses.\107\
---------------------------------------------------------------------------

    \105\ See, e.g., supra note 73.
    \106\ See, e.g., supra note 40.
    \107\ See, e.g., supra note 61.
---------------------------------------------------------------------------

    The Commission is not proposing to standardize the use of rating 
symbols by NRSROs. While the symbols used by an NRSRO to distinguish 
securities of varying risks may technically differ both in form and in 
meaning from those used by other NRSROs (e.g., S&P's lowest investment 
grade rating category for corporate debt securities is ``BBB'' and 
Moody's is ``Baa''), the similarities in NRSROs'' rating symbols 
(including the symbols previously used by entities that received NRSRO 
no-action letters but no longer exist) suggests the existence of a 
market-based standard.
    Similarly, there appears to be an existing market-based standard 
for credit rating agencies to have a consistent number of rating 
categories for distinguishing securities of varying risks. This latter 
standard is important for purposes of the NRSRO concept because a 
number of Commission rules referencing the term ``NRSRO'' also 
reference the NRSRO's levels of rating categories. For example, 
paragraph (c)(2)(vi)(F) of the net capital rule sets forth regulatory 
capital charges for proprietary positions of broker-dealers in 
nonconvertible debt securities rated in ``one of the four highest 
rating categories'' by at least two NRSROs.
    Questions: Should the Commission continue to rely on existing 
market-based standards for rating symbols and rating categories, or 
should specific standards be incorporated into the definition of the 
term ``NRSRO''? If the latter, what standards are appropriate?

C. Statistical Models

    In the 2003 Concept Release, the Commission inquired whether credit 
rating agencies that solely use statistical models and no other 
qualitative inputs should be able to qualify as NRSROs. There was a 
general consensus among commenters that computerized statistical models 
may be helpful in the credit rating process, but that a credit rating 
agency that solely uses statistical models should not qualify as an 
NRSRO.\108\ Most commenters responding to this question identified 
limitations with regard to the use of such models for providing in-
depth credit analysis.\109\ One commenter stated that the Commission 
staff does not have the expertise to evaluate the types of models used 
by most credit rating agencies.\110\
---------------------------------------------------------------------------

    \108\ See, e.g., supra notes 59, 73, and 92.
    \109\ See, e.g., supra note 88.
    \110\ See, e.g., supra note 84.
---------------------------------------------------------------------------

    However, one commenter noted that purely quantitative credit models 
have gained acceptance by credit risk managers in recent years, and 
that such models should be further considered before restricting NRSRO 
status to companies who do not solely rely on statistical models.\111\
---------------------------------------------------------------------------

    \111\ See, e.g., supra note 41.
---------------------------------------------------------------------------

    Although commenters were generally of the view that credit rating 
agencies that rely solely on statistical models should not qualify as 
NRSROs, the Commission, in proposing to define the term ``NRSRO,'' is 
not precluding through this proposed definition the possibility that a 
credit rating agency with a more quantitative business model than the 
current NRSROs could meet the definition of NRSRO. Accordingly, the 
proposed definition of the term ``NRSRO'' and the interpretations to 
the definition contained in this release should not be construed as 
excluding a credit rating agency that significantly relies on 
quantitative statistical models in developing credit ratings.
    Questions: Should a credit rating agency that relies solely or 
primarily on statistical models be able to meet the proposed NRSRO 
definition? If so, under what circumstances? The Commission also 
requests comment on guidelines for assessing the relevance and 
reliability of statistical models used in the ratings process.

[[Page 21318]]

D. Provisional NRSRO Status

    In the past, a number of observers have criticized the regulatory 
use of the NRSRO concept--particularly the ``national recognition'' 
requirement--as creating a substantial barrier to entry. In essence, 
these critics contend that important users of securities ratings have a 
regulatory incentive to obtain ratings issued by NRSROs, and that 
without NRSRO status new entrants encounter great difficulties 
achieving the ``national recognition'' necessary to obtain an NRSRO no-
action letter.
    For example, the U.S. Department of Justice (``DOJ''), commenting 
on the Commission's 1997 rule proposal, opposed the use of the 
``national recognition'' requirement because, in its view, that 
criterion likely creates a ``nearly insurmountable barrier to new entry 
into the market for NRSRO services.'' \112\ DOJ believed that, while 
the historical dominance of Moody's and S&P had eroded in recent years 
for certain types of securities ratings, the overall level of market 
power they retained continued to be a competitive concern. To 
ameliorate entry barriers, DOJ suggested the Commission consider giving 
``provisional'' NRSRO status (for the first 12 to 18 months of 
existence) to newly-formed credit rating affiliates of established, 
well-capitalized firms that have reputations for quality financial 
analysis in the investment community (e.g., investment banks, 
commercial banks, insurance companies, consulting firms, or accounting 
firms). DOJ also recommended the Commission consider ``provisional'' 
NRSRO status for foreign rating agencies, and indicated they might 
initially specialize in rating U.S. companies with substantial 
operations abroad.
---------------------------------------------------------------------------

    \112\ See Comments of the United States Department of Justice in 
the Matter of: File No. S7-33-97 Proposed Amendments to Rule 15c3-1 
under the Securities Exchange Act of 1934 (March 6, 1998).
---------------------------------------------------------------------------

    In response to these concerns, the Commission, in the 2003 Concept 
Release, sought comment on whether to consider a ``provisional'' NRSRO 
status for credit rating agencies that comply with NRSRO recognition 
criteria but lack national recognition. Most commenters generally did 
not support the concept of ``provisional'' NRSROs.
    Commenters supporting provisional NRSROs indicated that permitting 
them could promote competition among credit rating agencies by 
facilitating the entry of high-quality but lesser-known credit rating 
agencies.\113\ One commenter stated that credit rating agencies that 
provide quality ratings but are not national in nature could be 
provisional NRSROs,\114\ while another commenter represented that it 
would support a time-limited provisional NRSRO status if the Commission 
retains the ``widely accepted'' criterion.\115\
---------------------------------------------------------------------------

    \113\ See, e.g., supra note 87.
    \114\ See, e.g., supra note 41.
    \115\ See, e.g., supra note 63.
---------------------------------------------------------------------------

    Commenters opposing the idea of provisional NRSROs represented that 
permitting two classes of NRSROs would likely cause marketplace 
confusion,\116\ and that permitting provisional NRSROs would have 
little, if any, effect on a credit rating agency's ability to compete 
with the larger NRSROs.\117\ Several commenters also indicated that 
certain investors likely would not use ratings from ``provisional'' 
NRSROs for regulatory purposes because securities purchased based on a 
provisional NRSRO's ratings would possibly have to be sold if the 
provisional NRSRO failed to continue to meet the definition.\118\
---------------------------------------------------------------------------

    \116\ See, e.g., supra note 100.
    \117\ See, e.g., supra note 61.
    \118\ Id.
---------------------------------------------------------------------------

    The Commission has considered the responses to the 2003 Concept 
Release and has decided at present against creating a ``provisional'' 
NRSRO status. The Commission's use of the term ``NRSRO'' is intended to 
reflect the fact that the marketplace views a credit rating agency's 
ratings as credible and reliable. Without such assurance as to the 
quality of the ratings issued by a credit rating agency, it may be 
inappropriate to rely upon a credit rating agency's ratings as a proxy 
for credit quality in regulation.
    The Commission understands that the rationale for permitting 
provisional NRSROs is to promote competition in the credit rating 
industry. To this end, defining the term ``NRSRO'' to include credit 
rating agencies that confine their activities to limited sectors of the 
debt market or to limited (or largely non-U.S.) geographic areas may be 
a more reasonable approach that attempts to address the concerns raised 
by commenters and preserve the Commission's intended regulatory 
objectives. The Commission also notes with respect to the competitive 
concerns raised by commenters that since the term ``NRSRO'' was first 
used in the mid-1970's, several credit rating agencies have been able 
to enter the credit rating business and achieve the requisite level of 
market acceptance to receive NRSRO no-action letters.
    Question: Does the Commission's proposed NRSRO definition and 
approach for promoting competition address the competitive concerns 
raised by commenters' supporting provisional NRSROs?

E. Staff No-Action Process

    In the 2003 Concept Release, the Commission asked a series of 
procedural questions regarding the NRSRO concept. Across the board, 
commenters strongly supported Commission action to enhance the clarity 
of the process. However, a number of commenters also raised concerns 
about the extent of the Commission's legal authority to regulate or 
impose requirements on NRSROs.\119\ In the absence of Congressional 
action, we are proposing to adopt a comprehensive definition of the 
term ``NRSRO,'' which we believe to be an appropriate balance within 
the confines of the Commission's existing legal authority.
---------------------------------------------------------------------------

    \119\ See, e.g., supra note 40.
---------------------------------------------------------------------------

    As noted above, the Commission has never adopted a definition of 
the term. The Commission preliminarily believes that the proposed 
components of the NRSRO definition, discussed in detail above, would be 
a significant step forward in providing greater clarity in determining 
whether an entity's ratings should be relied on as NRSRO ratings for 
purposes of the securities laws, and Commission rules and regulations. 
An entity that meets the proposed definition would be an NRSRO.
    While we believe that adopting a definition of NRSRO could help 
address commenters' concerns regarding transparency, we understand that 
credit rating agencies might desire to continue to seek staff no-action 
letters in order to provide some measure of certainty to those entities 
relying on ratings provided by credit rating agencies. As such, and in 
light of the long-standing reliance by broker-dealers, issuers, 
investors and others on the existing staff no-action process, if we 
were to adopt a definition of NRSRO, we plan to continue to make our 
staff available to provide no-action letters as appropriate to those 
entities that choose to seek it. The continued provision of staff no-
action letters, where appropriate, is intended to provide more 
certainty.
    Currently, a credit rating agency initiates the no-action letter 
process by requesting a no-action letter that will state that the 
Commission staff will not recommend enforcement action against persons 
who use the firm's credit ratings for purposes of the Commission's net 
capital rule. Upon receipt of such a request, the Commission staff 
typically sends a letter to the credit rating agency requesting 
detailed information

[[Page 21319]]

regarding the criteria discussed above. After receiving this detailed 
information, the Commission staff meet with the credit rating agency 
for an on-site meeting. During this meeting, the credit rating agency's 
senior management, analysts, and other persons who are knowledgeable 
about the firm's policies and procedures are interviewed. The 
Commission staff also contacts and interviews references provided by 
the credit rating agency and others to assess, among other things, the 
references' use of the credit rating agency's ratings, whether they 
believe the credit rating agency issues credible and reliable ratings, 
and how the credit rating agency compares to other credit rating 
agencies.\120\ The Commission staff then determines whether the credit 
rating agency meets the NRSRO criteria and either issues the requested 
no-action letter, or informs the credit rating agency of its decision 
not to so issue a letter.\121\
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    \120\ These interviews have been useful indicators of a credit 
rating agency's marketplace recognition, and the Commission 
anticipates that, in connection with the no-action process, the 
staff will continue to interview references and other predominant 
users of securities ratings in determining which credit rating 
agencies should receive a no-action letter.
    \121\ When issuing an NRSRO no-action letter, the Commission 
staff has consistently conditioned such letters on credit rating 
agencies not representing in any of their ratings, marketing, or 
similar literature that the Commission considers the credit rating 
agency to be an NRSRO. See, e.g., supra note 2.
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    There was strong support in response to the 2003 Concept Release 
for the Commission to establish a time period to serve as a goal for 
acting on requests for NRSRO status.\122\ Some commenters addressing 
this issue thought that the process for seeking NRSRO status should 
include deadlines once a credit rating agency has submitted all 
required information, and that such a time period could enhance the 
market's perception of the NRSRO process and afford greater certainty 
to a credit rating agency as to when a ruling will be made on its 
request.\123\
    Some commenters believed that the Commission should act on a 
request for a no-action letter within 90 to 120 days after an entity 
has submitted all required information.\124\ Some commenters noted, 
however, that flexibility should exist if circumstances arise and an 
additional investigation needs to be conducted.\125\ Several commenters 
stated that credit rating agencies that do not obtain no-action letters 
should be notified as to why so that they can improve their operations 
in the specified areas and increase their chances of submitting a 
successful request in the future.\126\
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    \122\ See, e.g., Letter from Andrew Fight to Jonathan G. Katz, 
Secretary, Commission (July 25, 2003).
    \123\ See, e.g., supra note 56.
    \124\ See, e.g., supra note 46.
    \125\ See, e.g., supra note 61.
    \126\ See, e.g., supra note 100.
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    In this regard, we would expect that no-action requests would be 
considered by the staff, and resolved, in a timely fashion.\127\ The 
Commission believes that, if it were to adopt a definition of the term 
``NRSRO,'' the staff should be able to act on NRSRO no-action requests 
within 90 days after a credit rating agency has submitted all necessary 
information.\128\
    Like any staff no-action position, the staff's views on whether an 
entity meets the definition of NRSRO would be conditioned on the facts 
and representations made by the entity.\129\ Of course, if the facts 
and circumstances upon which the staff relied to provide its guidance 
change, the staff position may no longer be applicable. In this regard, 
given the changing market conditions in this context, we understand 
that the staff will include expiration dates in NRSRO no-action letters 
that it issues. In addition, the staff's views on issues may change 
from time-to-time, in light of reexamination, new considerations, or 
changing conditions that indicate that its earlier views are not longer 
in keeping with the objectives of the proposed NRSRO rule or with the 
regulatory use of NRSRO ratings.
---------------------------------------------------------------------------

    \127\ As part of this process, the Commission staff will inform 
the Commission promptly upon receipt of a request for a no-action 
letter from a credit rating agency.
    \128\ The information provided to the staff by a credit rating 
agency to obtain a no-action letter will be accorded confidential 
treatment to the extent permitted by law. However, it is the 
responsibility of the credit rating agency to request 
confidentiality under the appropriate Commission rules. See 17 CFR 
200.83.
    \129\ See generally 17 CFR 202.2. No-action requests should be 
directed to an appropriate officer of the Commission's staff. Id. 
The no-action letter process is an informal procedure that permits 
the public to request the views of the Commission staff on issues or 
activity that may raise compliance issues under federal securities 
law. In a no-action letter, the Commission staff states that it will 
not recommend enforcement action to the Commission with respect to 
identified rules or statutory provisions if the requesting party 
acts in accordance with specific facts and representations made in 
its letter. In some instances, the Commission staff will state that 
it is not able to give such assurance. The Commission takes the 
position that no-action letters do not constitute Commission 
precedent and do not bind subsequent Commission action. Although 
informal guidance from Commission staff assists the public in 
understanding how to comply with the Commission's rules and 
policies, the Commission reserves the right to act contrary to staff 
advice. See Informal Guidance Program for Small Entities, Release 
No. 33-7407 (March 27, 1997), 62 FR 15604 (April 4, 1997); and 
Procedures for Rendering Informal Advice, Release No. 33-6253 
(October 28, 1980), 45 FR 72644 (November 3, 1980). See also 17 CFR 
202.1(d) (``In certain instances an informal statement of the views 
of the Commission may be obtained. The staff, upon request or on its 
own motion, will generally present questions to the Commission which 
involve matters of substantial importance and where the issues are 
novel or highly complex, although the granting of a request for an 
informal statement by the Commission is entirely within its 
discretion.'').
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IV. General Request for Comment

    The Commission seeks comment generally on all aspects of proposed 
Exchange Act Rule 3b-10. In addition to the specific requests for 
comment found throughout this release, the Commission invites general 
comments on the proposed definition and the interpretations. The 
Commission also seeks comment on whether to expand the text of the 
proposed rule to include the interpretations of the components 
discussed in this release, or other interpretations. Furthermore, the 
Commission invites interested persons to submit written comments and 
data on any aspects of the proposed rule.

V. Paperwork Reduction Act

    Proposed Rule 3b-10 would not impose a new ``collection of 
information'' within the meaning of the Paperwork Reduction Act of 
1995.\130\
---------------------------------------------------------------------------

    \130\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

VI. Consideration of the Costs and Benefits of the Proposed Rule

    The Commission is sensitive to the costs and benefits that result 
from its rules. We have identified certain costs and benefits of the 
proposed rule and request comment on all aspects of this cost-benefit 
analysis, including identification and assessment of any costs and 
benefits not discussed in the analysis. The Commission requests data to 
quantify the costs and the value of the benefits identified. The 
Commission seeks estimates and views regarding these costs and benefits 
from market participants who might be impacted by the proposed rule, 
including credit rating agencies, independent credit analysts, broker-
dealers, mutual fund companies, securities issuers, and investors.

A. Benefits

    The proposed rule would define the term ``NRSRO'' and thereby 
enhance the use of the NRSRO concept in Commission rules and 
regulations. Specifically, it would provide greater clarity to 
determine whether credit rating agencies are NRSROs. This would also 
assist credit rating agencies that are currently NRSROs in 
understanding how they can continue to meet the definition. For credit 
rating agencies that are not currently NRSROs, the definition would 
provide a better

[[Page 21320]]

understanding of the enhancements necessary to meet the definition. 
This could reduce concerns related to barriers to entry for credit 
rating agencies seeking to become NRSROs. Moreover, concerns about 
barriers to entry also could be reduced by the interpretations of the 
proposed definition that would recognize credit rating agencies with an 
expertise in a particular industry or geographic region. This component 
could be particularly beneficial to smaller credit rating agencies in 
their efforts to meet the proposed definition of NRSRO.
    By lowering the barriers to entry identified above, the proposed 
rule could potentially increase the number of NRSROs. Issuers would be 
provided with more choices in terms of selecting NRSROs to rate their 
debt securities, which could lower their costs for this service. The 
greater competition in the market for credit ratings and analysis could 
provide for more credible and reliable ratings. Greater competition 
also could stimulate innovation in the technology and methods of 
analysis for issuing credit ratings, which could further lower barriers 
to entry.
    As previously noted, the NRSRO concept was first used by the 
Commission for the purposes of determining capital charges for broker-
dealers with respect to their proprietary debt securities. Broker-
dealers benefited from this use of the NRSRO concept in that it 
provided a simple regulatory benchmark. At the same time, the NRSRO 
concept benefited customers and counterparties of broker-dealers by 
linking the capital charge (and, consequently, the broker-dealers' 
capital adequacy) to a rating that is recognized by the marketplace as 
reliable and credible. These benefits would continue under the proposed 
rule.
    The benefit of the NRSRO concept as a regulatory benchmark and the 
beneficial impact of the proposed definition is indicated by its use in 
various other Commission rules and regulations; namely, Regulation S-
B,\131\ Regulation S-K,\132\ Securities Act Rule 134 (``Communications 
not deemed a prospectus''),\133\ Securities Act Rule 436 (``Consents 
requires in special cases''),\134\ Form S-3,\135\ Form F-2,\136\ Form 
F-3,\137\ Exchange Act Rule 3a1-1 (``Exemption from the definition of 
``Exchange'' under the Section 3(a)(1) of the Act''),\138\ Exchange Act 
Rule 10b-10 (``Confirmation of transactions''),\139\ Exchange Rule 
15c3-1 (``Net capital requirements for brokers or dealers''),\140\ 
Exchange Act Rule 15c3-1a (``Options''),\141\ Exchange Act Rule 15c3-1f 
(``Optional market and credit risk requirements for OTC derivatives 
dealers''),\142\ Exchange Act Rule 15c3-3a (``Exhibit A--formula for 
determination reserve requirement of brokers and dealers under Sec.  
240.15c3-3''),\143\ Rule 101 of Regulation M under the Exchange Act 
(``Activities by distribution participants''),\144\ Rule 102 of 
Regulation M under the Exchange Act (``Activities by issuers and 
selling security holders during a distributions''),\145\ Rule 300 of 
Regulation ATS under the Exchange Act (``Definitions''),\146\ 
Investment Company Act Rule 2a-7 (``Money market funds''),\147\ 
Investment Company Act Rule 3a-7 (``Issuers of asset-backed 
securities''),\148\ Investment Company Act Rule 5b-3 (``Acquisition of 
repurchase agreement or refunded security treated as acquisition of 
underlying securities''),\149\ and Investment Company Act Rule 10f-3 
(``Exemption for the acquisition of securities during the existence of 
an underwriting or selling syndicate'').\150\ The concept also has been 
used in federal statutes, state laws, and foreign laws and 
regulations.\151\ The importation of a market assessment of 
creditworthiness into a regulation benefits the affected entities by 
linking a regulatory requirement to a market determined benchmark. 
Thus, the proposed rule would result in the benefits described above by 
codifying the meaning of the term NRSRO.
---------------------------------------------------------------------------

    \131\ 17 CFR 228.10.
    \132\ 17 CFR 229.10.
    \133\ 17 CFR 230.134.
    \134\ 17 CFR 230.436.
    \135\ 17 CFR 239.13.
    \136\ 17 CFR 239.32.
    \137\ 17 CFR 239.33.
    \138\ 17 CFR 240.3a1-1.
    \139\ 17 CFR 240.10b-10.
    \140\ 17 CFR 240.15c3-1.
    \141\ 17 CFR 240.15c3-1a.
    \142\ 17 CFR 240.15c3-1f.
    \143\ 17 CFR 240.15c3-3a.
    \144\ 17 CFR 242.101.
    \145\ 17 CFR 242.102.
    \146\ 17 CFR 242.300.
    \147\ 17 CFR 270.2a-7.
    \148\ 17 CFR 270.3a-7.
    \149\ 17 CFR 270.5b-3.
    \150\ 17 CFR 270.10f-3.
    \151\ See, e.g., supra notes 14, 15, and 16.
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B. Costs

    The proposed rule would impose some costs on existing NRSROs. They 
could incur some costs in evaluating themselves against the proposed 
definition, and in seeking renewal of their no-action letters, should 
the Commission adopt a definition of NRSRO. However, in this regard, we 
note that the proposed definition of ``NRSRO'' is generally consistent 
with the criteria historically used by the Commission staff to identify 
NRSROs for purposes of no-action relief under the Commission's net 
capital rule.
    The proposed definition would not impose direct costs on credit 
rating agencies that do not currently meet the proposed definition of 
``NRSRO,'' since these entities would not be within its scope. A non-
NRSRO credit rating agency likely would incur costs if it sought to 
become an NRSRO, or needed to enhance its activities and operations to 
meet the NRSRO definition. An entity that is recognized nationally by 
the predominant users of credit ratings as issuing credible and 
reliable ratings generally would meet the proposed definition of 
``NRSRO'' or would be able to meet the definition with little 
incremental cost. Accordingly, a credit rating agency seeking to meet 
the definition of ``NRSRO'' would not incur costs beyond those that 
normally would be expended to gain acceptance in the marketplace, on a 
national level, as a credit rating agency that is recognized as issuing 
credible ratings. As such, the Commission does not believe that the 
proposed definition would increase costs for a rating agency seeking to 
be an NRSRO.
    The Commission also notes that the internet permits credit rating 
agencies to publish their ratings to a worldwide audience--i.e., make 
the ratings publicly available--for a minimal cost. Thus, a credit 
rating agency could meet this component of the proposed definition 
without incurring substantial costs. Moreover, under the proposed 
definition, a credit rating agency could become an NRSRO if it is 
generally accepted in the financial markets as an issuer of credible 
and reliable ratings for a particular industry or geographic segment. 
This could make it easier for a smaller entity, with a specific ratings 
expertise, to become an NRSRO. As such, over time, the proposed 
definition could reduce costs by making it easier for a credit rating 
agency that focuses on a particular geographic area or sector to be an 
NRSRO.
    The Commission seeks comment on the costs that would be incurred by 
a non-NRSRO credit rating agency to meet the proposed definition. As 
mentioned above, to assist the Commission in evaluating the costs and 
benefits that may result from the proposed rule, the Commission 
requests comment on the potential costs and benefits identified in the 
release, as well as any other costs or benefits that may result from 
the proposed rule. In particular, the Commission requests comments on 
the potential costs for any modification to

[[Page 21321]]

both computer systems and surveillance mechanisms and for information 
gathering, management, and recordkeeping systems or procedures, as well 
as any potential benefits resulting from the proposals for registrants, 
issuers, investors, brokers or dealers, other securities industry 
professionals, regulators, and others. The commenters should provide 
analysis and data to support their views on the costs and benefits.
    The Commission has found that opinions differ regarding the 
critical elements for success in the credit rating business (e.g., 
staff, experience, capital), and this may lead to varying views on the 
precise nature and extent of the costs and benefits. The Commission 
poses the following questions regarding the proposed rule: What are the 
costs for an entity to operate as a credit rating agency that is 
recognized on a national level by the predominant users of credit 
ratings as issuing credible and reliable ratings? What are the costs 
for an entity to enter into the credit rating business with respect to 
rating securities within a specific industry or geographic segment? 
What additional costs would such an entity incur to achieve national 
recognition?
    In answering these questions, commenters should provide detailed 
information on, or estimates of, the costs associated with maintaining 
an office, a staff, and the necessary communications and information 
systems and equipment as well as costs related to publishing credit 
ratings. We also seek comment on whether costs related to technology 
have significantly increased in recent years.

VII. Consideration on Burden and Promotion of Efficiency, Competition, 
and Capital Formation

    Section 3(f) of the Exchange Act requires the Commission, whenever 
it engages in rulemaking and must consider or determine if an action is 
necessary or appropriate in the public interest, to consider whether 
the action would promote efficiency, competition, and capital 
formation.\152\ In addition, Section 23(a)(2) of the Exchange Act 
requires the Commission, when making rules under the Exchange Act, to 
consider the impact that such rules would have on competition.\153\ 
Exchange Act Section 23(a)(2) prohibits the Commission from adopting 
any rule that would impose a burden on competition not necessary or 
appropriate in furtherance of the purposes of the Exchange Act.
---------------------------------------------------------------------------

    \152\ 15 U.S.C. 78c(f).
    \153\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    The Commission preliminarily believes that the proposed definition 
of ``NRSRO'' would not impose any burdens on efficiency, capital 
formation and competition and would, in fact, promote these interests. 
The proposed definition would provide greater clarity to the process by 
which credit rating agencies become NRSROs. This would also assist 
credit rating agencies that are currently NRSROs in understanding how 
they could meet the proposed definition. For credit rating agencies 
that are not currently NRSROs, the definition would provide a better 
understanding of the enhancements necessary to meet the proposed 
definition. This could reduce concerns regarding barriers to entry for 
credit rating agencies seeking to become NRSROs. Moreover, concerns 
about barriers to entry also could be reduced by the component of the 
proposed definition that would recognize credit rating agencies with an 
expertise in a particular industry or geographic region. This component 
could be particularly beneficial to smaller credit rating agencies in 
their efforts to meet the proposed NRSRO definition.
    By lowering any barriers to entry discussed above, the proposed 
rule could potentially increase the number of NRSROs. Issuers could be 
provided with more choices in terms of selecting NRSROs to rate their 
debt securities, which would lower their costs for this service. The 
greater competition in the market for credit ratings and analysis could 
provide for more credible and reliable ratings. Greater competition 
also could stimulate innovation in the technology and methods of 
analysis for issuing credit ratings, which could further lower barriers 
to entry.
    The Commission believes the resulting increased clarity from the 
proposed definition could have some positive impact on capital 
formation. As noted in the Benefits Section in Section VI., a number of 
Commission rules and regulations use the NRSRO concept. For example, 
certain regulations provide safe harbors to small businesses issuing 
securities and to all issuers in making non-financial statements in 
securities registrations.\154\ The NRSRO concept also is used in 
defining which debt securities can be held by a money market fund.\155\ 
In addition, as noted throughout, the NRSRO concept is used in the 
broker-dealer capital rule. Finally, states, foreign governments, and 
private entities use the NRSRO concept as well. The proposed 
definition, by codifying a component of the NRSRO concept, would 
provide clarity to its use in these rules and regulations which all 
relate in some respects to the issuance of debt securities. 
Accordingly, the proposed definition could assist in the underwriting 
and making of markets in corporate debt.
---------------------------------------------------------------------------

    \154\ See, e.g., 17 CFR 228.10 and 17 CFR 229.10.
    \155\ 17 CFR 270.2a-7.
---------------------------------------------------------------------------

    While we believe the proposed definition could lower any barriers 
to entry and promote competition, we recognize that some market 
participants have argued that the NRSRO concept impedes competition by 
creating unreasonable barriers to entry. There is a widespread view 
that one of the most significant natural barriers into the credit 
rating business is the current dominance of a few highly-regarded, 
well-capitalized rating agencies that pioneered the industry many 
decades ago. This view may, in part, be a consequence of the fact that, 
until the mid-1970s, only a handful of firms (primarily three of the 
five current NRSROs) issued credit ratings on securities. These firms 
developed substantial brand names during the period when they were the 
only entities issuing securities ratings. Since the mid-1970's, 
however, there has been a steady increase in the number of credit 
rating agencies operating in the U.S. and internationally, so that 
today it is estimated that there are more than 100 active credit rating 
agencies worldwide.\156\
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    \156\ See Credit Ratings and Complementary Sources of Credit 
Quality Information, Basel Committee on Banking Supervision Working 
Papers (August 2000), at 14 (``[I]n September 1999, it was believed 
that there might be some 130 [rating] agencies world-wide, although 
industry sources indicated this number was closer to 150.''). See 
also SEC Hearing Transcript, supra note 30, (November 21, 2003) 
(testimony of Gay Huey Evans, Director, Markets and Exchanges 
Division, The Financial Services Authority) (``There are 
[approximately] 150 [rating] agencies in total around the world and 
they vary in size and scope.'').
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    It should be noted that this growth in the number of entities 
issuing securities ratings began after the Commission started using the 
NRSRO concept for regulatory purposes. The expansion suggests a growing 
interest among market participants for advice about credit quality, and 
that new entrants are able to develop a following for their credit 
judgments. The Commission staff also has provided no-action letters to 
several small credit rating agencies since it began using the NRSRO 
concept for regulatory purposes.\157\ Several of

[[Page 21322]]

these entities received no-action letters within five or six years of 
the date they began issuing securities ratings. The Commission 
preliminarily believes this may demonstrate that the proposed ``NRSRO'' 
definition could be met by small firms and, accordingly, appears to 
indicate that the proposed definition would not act as an unreasonable 
barrier to their meeting the definition of NRSRO.
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    \157\ Duff & Phelps, Inc. began issuing credit ratings in 1974 
and became an NRSRO in 1982. McCarthy Crisanti & Maffei began 
issuing credit ratings in 1975 and became an NRSRO by 1983. IBCA 
Limited and IBCA Inc. began issuing credit ratings in 1978 and 1985, 
respectively, and were designated together as an NRSRO in 1990. 
Thomson BankWatch, Inc. entered the credit rating business in 1974 
and became an NRSRO in 1991. A.M. Best began issuing credit ratings 
in 1999 and became an NRSRO in 2005.
---------------------------------------------------------------------------

    The Commission believes that, at this time, eliminating the NRSRO 
concept would not be prudent, nor in the interest of investors and 
securities market participants. For example, the concept provides an 
easily ascertainable and non-arbitrary regulatory benchmark for broker-
dealers to compute their capital charges.\158\ At the same time, it 
provides that broker-dealers will use credit ratings that are 
recognized by the marketplace as credible and reliable and issued by 
entities that have adequate financial resources and operational 
capability. These assurances enhance a broker-dealer's capital adequacy 
and, thereby, protect customers and counterparties. Users of credit 
ratings and others generally agree there must be substantive threshold 
standards for being an NRSRO for the term to have meaning.\159\ In 
essence, the proposed NRSRO definition is meant to reflect the fact 
that the marketplace views a rating agency's ratings as credible and 
reliable.
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    \158\ See, e.g., Letter from Cheryl Kallem, Chair, SIA Capital 
Committee, to Jonathan G. Katz, Secretary, Commission (July 28, 
2003).
    \159\ See, e.g., SEC Hearing Transcript, supra note 30 (November 
15, 2002) (testimony of Frank A. Fernandez, Senior Vice President, 
Chief Economist and Director of Research, The Securities Industry 
Association and testimony of Gregory A. Root, Executive Vice 
President, Dominion Bond Rating Service Limited).
---------------------------------------------------------------------------

    The Commission requests comment on all aspects of this analysis 
and, in particular, on whether the proposed NRSRO definition would 
place a burden on competition.

VIII. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \160\ we must advise the Office of 
Management and Budget as to whether the proposed regulation constitutes 
a ``major'' rule. Under SBREFA, a rule is considered ``major'' where, 
if adopted, it results or is likely to result in: (1) An annual effect 
on the economy of $100 million or more (either in the form of an 
increase or a decrease); (2) a major increase in costs or prices for 
consumers or individual industries; or (3) significant adverse effect 
on competition, investment or innovation.
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    \160\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996) 
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note 
to 5 U.S.C. 601).
---------------------------------------------------------------------------

    If a rule is ``major,'' its effectiveness will generally be delayed 
for 60 days pending Congressional review. We request comment on the 
potential impact of the proposed rule on the economy on an annual 
basis. Commenters are requested to provide empirical data and other 
factual support for their view to the extent possible.

IX. Regulatory Flexibility Act

    Pursuant to section 605(b) of the Regulatory Flexibility Act 
(``RFA''), the Commission hereby certifies that proposed Rule 3b-10, 
would not, if adopted, have a significant economic impact on a 
substantial number of small entities. Under the RFA, the term ``small 
entity'' shall have the same meaning as the RFA defined term ``small 
business.'' According to section 601(3) of the RFA, ``the term `small 
business' has the same meaning as the term `small business concern' 
under section 3 of the Small Business Act (15 U.S.C. 632), unless an 
agency, after consultation with the Small Business Administration and 
after opportunity for public comment, establishes one or more 
definitions of such term which are appropriate to the activities of the 
agency and publishes such definition(s) in the Federal Register.'' If 
the agency has not defined the term for a particular purpose, the Small 
Business Act states that ``a small business concern * * * shall be 
deemed to be one which is independently owned and operated and which is 
not dominant in its field of operation.'' The Commission has not 
defined the term ``small entity'' in the context of NRSROs for purposes 
of the RFA. Therefore, for purposes of this rulemaking, the Commission 
is using the broader definition of ``small business concern'' as 
defined in the Small Business Act.
    Currently, there are five credit rating agencies that we believe 
would meet the proposed definition of ``NRSRO.'' Only two of the NRSROs 
are independently owned and operated. However, the two independently 
owned NRSROs are dominant in their respective fields as one has earned 
a national reputation for issuing ratings on insurance companies and 
the other on Canadian issuers. Accordingly, there are no small entities 
that currently would meet the proposed definition of NRSRO.
    As noted above, it has been estimated there are between 100 and 150 
entities that issue credit ratings or credit analysis.\161\ It is 
likely that a substantial number of these credit rating agencies are 
small entities. The proposed definition could have an impact on one of 
these small credit rating agencies if it sought to become an NRSRO. 
However, in this regard, the proposed definition of NRSRO would closely 
track the current process under which the staff issues no-action 
letters. Thus, while the proposed definition may impact a small credit 
rating agency, such impact would likely be small.
---------------------------------------------------------------------------

    \161\ See supra note 156.
---------------------------------------------------------------------------

    For the above reasons, the Commission certifies that proposed Rule 
3b-10 would not have a significant economic impact on a substantial 
number of small entities. The Commission requests comments regarding 
this certification. The Commission requests that commenters describe 
the nature of any impact on small businesses and provide empirical data 
to support the extent of the impact.

X. Statutory Authority

    Pursuant to the Securities Act of 1933, and particularly Sections 
7, 10, and 19 thereof, 15 U.S.C. 77g, 77j, and 77s, the Exchange Act, 
and particularly Sections 3(b), 15, 17, and 23 thereof, 15 U.S.C. 
78c(b), 78o(c)(3), 78q, and 78w, the Investment Company Act of 1940, 
and particularly Sections 6c and 38a thereof, 15 U.S.C. 80a-6, 80a-36, 
the Commission proposes to adopt Sec.  240.3b-10 of Title 17 of the 
Code of Federal Regulations in the manner set forth below.

Text of Proposed Rule

List of Subjects in 17 CFR Part 240

    Brokers, Fraud, Reporting and recordkeeping requirements, 
Securities.

    For the reasons set out in the preamble, Title 17, Chapter II, of 
the Code of Federal Regulations is proposed to be amended as follows.

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    1. The authority citation for part 240 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 
78w, 78x, 78ll, 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-
3, 80b-4, 80b-11, and 7201 et seq.; and 18 U.S.C. 1350, unless 
otherwise noted.
* * * * *
    2. Section 240.3b-10 is added to read as follows:

[[Page 21323]]

Sec.  240.3b-10  Definition of ``nationally recognized statistical 
rating organization.''

    The term nationally recognized statistical rating organization 
means any entity that:
    (a) Issues publicly available credit ratings that are current 
assessments of the creditworthiness of obligors with respect to 
specific securities or money market instruments;
    (b) 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
    (c) Uses systematic procedures designed to ensure credible and 
reliable ratings, manage potential conflicts of interest, and prevent 
the misuse of nonpublic information, and has sufficient financial 
resources to ensure compliance with those procedures.

    Dated: April 19, 2005.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 05-8158 Filed 4-22-05; 8:45 am]
BILLING CODE 8010-01-P