Written Statement of
Rating and Investment Information, Inc.
Submitted to the U.S. Securities and Exchange Commission
In Connection with the November 15 and 21, 2002
Credit Rating Agencies
(File No. 4-467)
November 14, 2002
Since 1975 when the U.S. Securities and Exchange Commission ("SEC" or "Commission") started relying upon the use of credit ratings issued by nationally recognized statistical rating organizations ("NRSROs") in its rule 15c3-1 (the "Net Capital Rule") as an indication of a security's liquidity, the U.S. and global securities marketplace has changed dramatically. Also since 1975, the number of regulatory applications that rely upon ratings issued by credit rating agencies recognized as NRSROs for purposes of the Net Capital Rule has increased dramatically. However, in that same time, the Commission's process for recognizing which credit rating agencies should be relied upon has not changed. The result is that in the year 2002, the only three NRSROs currently recognized by the staff of the Commission are the same three that the staff originally declared to be NRSROs in 1975.
As discussed below, Rating and Investment Information, Inc. ("R&I") believes that the Commission's current scheme for recognizing "qualified" rating agencies should be amended to reflect today's multiple regulatory uses of credit ratings. The Commission should formalize the process of recognizing rating agencies, and the criteria used should emphasize the quality of an agency's work rather than its national recognition. The hearings being convened by the Commission on November 15 and 21, 2002 in accordance with the Commission's study of rating agencies as mandated by the Sarbanes-Oxley Act of 2002 provide a good opportunity for the rating industry to share with the Commission (and the public) the latest developments of the rating agencies and their observations as to how the current regulatory framework can be improved for investors and the marketplace as rating services become increasingly more diverse and sophisticated.
II. Background on Rating and Investment Information, Inc.
R&I is the largest rating agency headquartered in Japan. In 2002, R&I rated nearly 74% of all Japanese issuers. R&I is a highly respected independent source of financial information for the overwhelming majority of U.S. broker-dealers and financial institutions that conduct operations in Japan, and provides a variety of ratings services to U.S. and foreign companies.1/ R&I's ratings are regularly announced and published by the leading financial electronic and print media both in Japan and in the United States. Many of these publications and online information services are relied upon by the U.S. financial services industry.
As of October 31, 2002, R&I provides ongoing rating services to 795 issuers, including 104 non-Japanese entities in connection with their 4,625 issues, including long term debt offerings, medium term notes, asset backed instruments and Euro-commercial paper. To provide ratings services for such a vast spectrum of securities for varied types of issuers, R&I relies on a highly skilled, independent team of analysts and other ratings professionals. As of October 31, 2002, R&I has a total staff of 145 employees. The professional staff consists of a considerable number of credit rating analysts and pension fund evaluation analysts. In total there are 61 credit rating analysts.
R&I's ratings process and issuer analyses all are geared towards one purpose - to ensure credible and consistent ratings. Morgan Stanley Dean Witter Japan ("MSDW-Japan") rated R&I as the best overall rating agency in yen-denominated securities two years in a row (2000 and 2001), ahead of all three NRSROs that conduct business in Japan - Standard & Poor's Corporation ("S&P"), Moody's Investors Service, Inc. ("Moody's"), and Fitch, Inc. ("Fitch"). This report studied the firms' rating methodologies, analyzed the correlation between a security's rating and the yield spread over the Japanese Government Bond in the secondary market,2/ and evaluated the persuasiveness of the rationale supporting a firm's ratings. Given R&I's experience in rating yen-denominated securities and its dominance in the Japanese market including Samurai Bonds (i.e., yen-denominated bonds issued in Japan by non-Japanese resident issuers), the MSDW-Japan study concluded that R&I was the most reliable overall source of ratings information for yen-denominated instruments.
An important measure of the consistency and quality of securities ratings is the default ratio for issues that have been assigned a particular rating. As a service to investors and the marketplace, R&I calculates and publishes a `broad definition default ratio," which is based on a twenty-five year market history and which indicates the probability that an issuer that has been given a publicly released rating will fall into default within a given period of time. During 2001, for example, the default ratio for companies issuing bonds that R&I has rated as AAA or AA was zero; the default ratio for issuers rated A or BBB was 0.4%; and that for BB or lower was 4.4%. R&I's broad definition default ratio demonstrates the strong correlation between R&I's ratings of an issuer and the likelihood of default.
R&I's rating system has been quite consistent in terms of default ratio in the longer term. R&I also calculates the rating transition matrix, which shows how ratings assigned to issuers change over a fixed period of time and the degree of change for each rating. This default study is helpful to market participants in gauging the consistency and reliability of R&I's ratings.
III. Background on NRSROs
Investors and market professionals historically have used securities ratings to gauge the creditworthiness of a particular issue.3/ The Commission significantly expanded the traditional use of ratings in 1975 when it adopted the Net Capital Rule under the Securities Exchange Act of 1934 ("Exchange Act"). The Net Capital Rule incorporated credit ratings by "nationally recognized statistical rating organizations" in certain of its provisions.4/ Rather than use securities ratings as a measure of creditworthiness, the Net Capital Rule created the NRSRO concept to measure liquidity. Currently, three rating agencies are designated by the Commission's staff as NRSROs for purposes of the Net Capital Rule: S&P, Moody's, and Fitch.
In the past, the staff of the Commission also recognized two agencies, IBCA and Thompson BankWatch, Inc. ("BankWatch"), as NRSROs for limited purposes. IBCA Limited, together with its subsidiary, IBCA, Inc., (collectively "IBCA"), which was acquired by Fitch, was designated as an NRSRO only with respect to its ratings of debt issued by banks, bank holding companies, U.K. building societies, broker-dealers and broker-dealers' parent companies, and bank-supported debt. Like IBCA, BankWatch, which has also been acquired by Fitch, was recognized as an NRSRO only with respect to ratings for debt issued by banks, bank holding companies, non-bank banks, thrifts, broker-dealers, and broker-dealers' parent companies.
These narrow designations of NRSRO status for specific purposes demonstrate the Commission's acknowledgment that the NRSRO designation is not "one size fits all." We concur; it would be unfair to preclude a rating organization from NRSRO status if it did not qualify for NRSRO status on the bases of all of its ratings, even though NRSRO designation is warranted for certain of its ratings or for its ratings of securities issued by certain types of issuers.
Similarly, if a rating agency has demonstrated that it possesses unique expertise in rating particular securities, or securities of a particular currency denomination, investors and the marketplace should be able to receive the benefit of this expertise. As a practical matter, investors and the marketplace will be significantly deprived of the full benefit of this expertise unless such rating agency is recognized as a NRSRO, at least with respect to those securities issues in which the rating agency has expertise.
B. Historical Background on NRSRO Designation
The initial purpose of incorporating the NRSRO standard into the Net Capital Rule was to use the ratings as a proxy for a security's liquidity.5/ Since that time, however, the use of NRSRO ratings in the federal securities laws and regulations has expanded considerably, as has reliance on those ratings by investors and the marketplace. While NRSRO ratings continue to be used as a liquidity standard under the Net Capital Rule, the term "NRSRO" remains undefined in SEC regulations, whether under the Net Capital Rule or elsewhere (e.g., the purchase criteria of money market mutual funds) and the process for determining who is an NRSRO remains unchanged. Meanwhile, both Congress and the Commission have incorporated the NRSRO concept for other purposes, primarily as indicia of a security's creditworthiness - the historical and predominant use of securities ratings.
Congress, for example, employed the term "NRSRO" when it defined "mortgage related security."6/ According to that definition, a mortgage-related security must, among other things, be rated in one of the two highest rating categories by at least one NRSRO. Congress did not define what it meant by "NRSRO," but its reliance on the term used in Commission rules is significant because it reflects a Congressional recognition that the "term has acquired currency as a term of art."7/ In the context of mortgage related securities, the NRSRO designation is important because it is used to distinguish "investment grade" from "non-investment grade" debt.
The Commission also has incorporated the term "NRSRO" in various rulemakings under the Securities Act of 1933 ("Securities Act"), the Exchange Act, the Investment Company Act of 1940 ("Investment Company Act"), and the Investment Advisers Act of 1940 ("Advisers Act" and collectively, the "Federal Securities Acts"). These rulemakings have incorporated the term "NRSRO" as it is used in the Net Capital Rule, often times by cross-referencing the Net Capital Rule. These other references to NRSROs are used for purposes other than identifying securities of a satisfactory liquidity under the Net Capital Rule.
For example, Investment Company Act rule 2a-7 requires a money market fund to limit its investment to eligible securities that are, among other things, rated in one of the two highest rating categories for short-term debt by the requisite number of NRSROs. Commission releases suggest that rule 2a-7 is intended to assist fund boards in assessing the credit risks of a particular security.8/ In addition, under the Securities Act, NRSRO ratings are permitted as a substitute for the float requirement to determine issuer eligibility for Form S-3.9/
C. Process of Obtaining Recognition as an NRSRO
Currently, the staff of the Division of Market Regulation reviews a rating agency to determine if it will be considered an NRSRO. If the staff determines that the rating agency meets its criteria for such status, it issues a no-action letter stating that it will not recommend action to the Commission if the rating organization is considered by registered broker-dealers to be an NRSRO for purposes of the Net Capital Rule.10/ In making its determination, the staff considers a number of criteria, including whether the rating organization is "nationally recognized," meaning the rating agency is recognized in the United States as an issuer of credible and reliable ratings by the predominant users of securities markets. The staff also looks at the operational capacity and reliability of each organization.11/
Although the Commission has greatly expanded the regulatory uses of ratings by NRSROs since the adoption of the Net Capital Rule in 1975, the process by which NRSROs are designated has not changed. Rating agencies seeking NRSRO designation still must approach the staff of the Division of Market Regulation for no-action relief in the context of the Net Capital Rule. Thus, applying the above-discussed criteria, but primarily with an eye to the liquidity issues most important under the Net Capital Rule, the Division makes the determination as to whether the rating agency qualifies as an NRSRO. SEC Commissioners have described this process as lacking "transparency."12/
IV. Arguments for Expansion and Standardization of NRSRO Certification
This current system of designating NRSROs is a lengthy and complicated process that is further impeded by a lack of clear rules and definitions. Although the concept of NRSROs originally was developed for the specific purposes of the Net Capital Rule, together the Commission and Congress have significantly expanded its applicability without providing a definition or acknowledging that the concept is now used well beyond its origins as a liquidity proxy.
The current designation process creates barriers preventing reliable ratings agencies from being designated as NRSROs. A streamlined certification process based upon clearly enumerated regulations would facilitate additional qualified rating agencies being designated as NRSROs. With this goal in mind, over the past decade, the Commission has considered revising the process by which NRSROs are designated. In 1994, the Commission issued a sweeping concept release, seeking input on various aspects of the NRSRO process. Later, in 1997, the Commission proposed amendments to the Net Capital Rule that defined the term "NRSRO" and set forth specific criteria to determine when a company qualifies for such status.13/ Although these proposed amendments were generally considered to be a positive development,14/ they have not been adopted by the Commission.
The Commission's expanded use of NRSRO ratings is an important component of its regulatory program. Just as the Commission relies on ratings for purposes beyond the scope of the Net Capital Rule, rating agencies also have expanded their ratings to new kinds of securities products. The Division charged with conferring NRSRO status, however, does so based on the very limited and narrow perspectives of the Net Capital Rule (i.e., only broker-dealers' uses of securities ratings) and is unable to consider other uses of the NRSRO designation that have been adopted by the Commission under the Federal Securities Acts.
The Commission should align the process of designating NRSROs more closely with the current uses of ratings. Just as the market for securities ratings is expanding and rating agencies are becoming more flexible to meet the needs of the marketplace, the Commission's regulatory policy is expanding with it, and is utilizing the NRSRO standard for more varied purposes. We would respectfully suggest that the current designation process has not kept pace with the Commission's or the industry's use of ratings.
The fact that the designation process has not kept pace with the Commission's regulatory programs has the effect of diluting or even undermining the efficacy of the regulations that incorporate the NRSRO standard. Ratings issued by NRSROs are used in the Corporation Finance area, for example, as a "litmus test" for determining the availability of information to the marketplace. Securities issues that are rated investment grade are determined to have sufficient information available in the marketplace; those securities that are rated "non-investment grade" are determined to have insufficient information in the marketplace.
The expanding uses of the NRSRO designation in Commission rules also increase the likelihood that issuers will select rating organizations based primarily on their NRSRO status, rather than on their actual ability to rate a particular security. Issuers understandably are more likely to seek the rating of an NRSRO rather than a rating agency not so recognized by the staff of the Division of Market Regulation. The issuer will engage the NRSRO because of the collateral benefits to the issuer itself (such as availability of short-form registration statements) and the broker-dealers that may act as market makers for the issuer's securities. The most qualified rating organization may not be considered merely because its ratings have not been found to be "nationally recognized" by the staff of the Division of Market Regulation. If industry parties will not use the agency's ratings because it is not an NRSRO, its ability to gain national recognition is stifled.
By limiting NRSRO status to those entities that are "nationally recognized" for purposes of determining the liquidity of a security, we would respectfully suggest that the industries regulated by the Divisions of Corporation Finance and Investment Management are disserved. The rules promulgated under the Securities Act, Investment Company Act, and Investment Advisers Act use the NRSRO designation primarily to determine the creditworthiness of a security. The entity best equipped to judge a security's creditworthiness may not necessarily be "nationally recognized" as that vague standard currently is interpreted by the Division of Market Regulation.
In some cases, non-NRSRO rating agencies are better qualified, through access and experience, than current NRSROs to provide accurate and in-depth rating information. This is particularly true in the case of R&I, which is the leading rating organization in Asia and particularly in Japan, rating four out of every five Japanese issues. As such, it has developed unique expertise in rating Japanese and other Asian issues. Investors and the marketplace, both in Japan and in the United States, significantly benefit from the expertise that R&I has developed after years of experience with such issues. Recognition of rating companies with unique expertise such as R&I is essential to effectively provide investors and the marketplace with the full range of resources that they need and deserve to make investment decisions.
An increase in the number of NRSROs reviewing companies will only have positive effects on the market. Information revealed will increase in both quantity and quality. Removing barriers to NRSRO status means that relevant data will be revealed to users of ratings. A robust and competitive rating environment also means that investment decisions will be made based on more and higher quality information.
R&I believes that the current regulatory structure regarding the use of credit ratings that is linked closely to the Commission's Net Capital Rule does not reflect the varied purposes of credit ratings in the marketplace or in other Commission rules. R&I believes that the role of rating agencies in the U.S. securities marketplace would be enhanced under a regulatory scheme that recognizes all rating agencies qualified to issue credible ratings of security issues, regardless of whether such rating agencies are "nationally recognized" for purposes of the Net Capital Rule. Therefore, R&I recommends that: 1) the Commission amend its regulations to formalize the process of recognizing rating agencies that issue credible ratings without such a strong emphasis on "national recognition" but rather in keeping with the multiple uses of credit ratings in both the marketplace and the regulatory environment; 2) the Commission permit limited purpose recognition of credit rating agencies for those agencies that have demonstrated an expertise in a discrete area of rating services (e.g., R&I's expertise with respect to yen-denominated securities); and 3) the Commission promptly act upon all pending NRSRO applications filed with the staff of the Division of Market Regulation in order to permit qualified rating agencies to compete with the original (and still the only) three NRSROs, thereby expanding the pool of available expertise and giving issuers more choices of rating agencies.
R&I appreciates the Commission's review of the role of credit rating agencies and the opportunity afforded to R&I to contribute to the dialog.
|1|| R&I provides rating information services to the following U.S.-affiliated financial institutions: AIG Holdings; Alliance Capital Asset Management; American Family Life Assurance Company; Bank of America Securities; Bank of America NA; Deutsche Bank Group; Bear Stearns (Japan) Ltd.; Brown Brothers Harriman & Co.; Cantor Fitzgerald Securities; Citibank NA; Cigna International Investment; Citicorp Securities (Japan) Ltd.; Cititrust & Banking Corp.; Fidelity Investment; Credit Suisse First Boston Securities; Frank Russell Company; Franklin Templeton Investments; G. E. International Inc.; Goldman Sachs (Japan) Ltd.; J.P. Morgan Chase Bank; J.P. Morgan Investment Management Inc.; J.P. Morgan Securities; Lehman Brothers Japan Inc.; Merrill Lynch Japan Inc.; Merrill Lynch Investment Managers; Morgan Stanley Dean Witter Japan Ltd.; Prudential Life Insurance; Salomon Smith Barney (Japan) Ltd.; and State Street Investment Management. In addition, R&I provides rating information services to the following non-U.S. financial institutions: HSBC Securities Ltd.; BNP Paribas Securities Ltd.; Deutsche Securities Ltd.; and WestLB Securities Ltd.
|2|| A strong correlation between a security's rating and its spreads in the secondary market is considered good evidence that investors in the market recognize the particular credit rating as accurate and an important reference for a decision regarding investment in the security. In recent years, among the rating companies in Japan, R&I has maintained the strongest correlation. R&I's correlation was 0.81 (May 2001) and 0.89 (May 2002). Japan Credit Rating Agency, Ltd.'s correlation during the same period was 0.71 and 0.80. Moody's was 0.68 and 0.75. S&P's was 0.64 and 0.73 respectively during the same period. This is based on the estimate provided by Mizuho Securities Co., Ltd. as MSDW-Japan does not officially publish the data.
|3|| See Richard Cantor & Frank Packer, The Credit Rating Industry, 19 FRBNY Q. Rev. 1, 2 (1994). The first rating agencies were established in the U.S. in the 1800s. Id.
|4|| Exchange Act rule 15c3-1. See Adoption of Amendments to rule 15c3-1 and Adoption of Alternative Net Capital Requirement for Certain Brokers and Dealers, Exchange Act Release No. 11497 (June 26, 1975).
|5|| See Testimony of Commissioner Isaac C. Hunt, Jr. Concerning the Role of Credit Rating Agencies in the U.S. Securities Markets, before the United States Senate Committee on Governmental Affairs, March 20, 2002 (hereinafter "Hunt testimony"). ("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 those securities that were not so highly rated.").
|6|| Section 3(a)(41) of the Exchange Act was added by the Secondary Mortgage Market Enhancement Act of 1984, Pub. L. No. 98-440, §101, 98 Stat. 1689, 1689 (1984).
|7|| H.R. Rep. No. 994, 98th Cong., 2d Sess. 46 (1984) (appending Statement of Charles C. Cox, Commissioner, Securities and Exchange Commission, to the Subcommittee on Telecommunications, Consumer Protection, and Finance of the House Committee on Energy and Commerce, Mar. 14, 1984).
|8|| See, e.g., Technical Revisions to the Rules and Forms Regulating Money Market Funds, Investment Company Act Release No. 22921 (Dec. 3, 1997), at I.B.4.c. (amended rule 2a-7 requires a "fund's board of directors to reassess whether an unrated or second tier security continues to present minimal credit risks only when the fund's adviser (or other person delegated portfolio management responsibilities) becomes aware that the security has been downgraded by any NRSRO below that NRSRO's two highest short-term rating categories"); Revisions to Rules Regulating Money Market Funds, Investment Company Act Release No. 21837 (Mar. 21, 1996), at II.C.2.a. ("NRSRO ratings assigned to demand features or the issuer of demand features may provide additional protection by ensuring input into the minimal credit risk determination by an outside source").
|9|| See Hunt testimony, supra note 5 ("[O]fferings of certain nonconvertible debt and preferred securities that are rated investment grade by at least one NRSRO can be registered on Form S-3 without the issuer satisfying a minimum public float test.").
|10|| See Capital Requirements for Brokers or Dealers Under the Securities Exchange Act of 1934, , Exchange Act Release No. 39457 (Dec. 17, 1997) ("1997 Proposing Release").
|11|| The specific criteria included in this assessment are: (1) the organizational structure of the rating organization; (2) the rating organization's financial resources; (3) the size and quality of the rating organization's staff; (4) the rating organization's independence from the companies it rates; (5) the rating organization's rating procedures; and (6) whether the rating organization has internal procedures to prevent the misuse of non-public information and whether those procedures are followed. Id.
|12|| SEC Proposes Ratings Disclosure, Publishes Concept Release on NRSROs, BNA SEC. L. DAILY (Sept. 1, 1994) (quoting then-Commissioner Mary Schapiro).
|13|| See 1997 Proposing Release.
|14|| It should be noted, however, that U.S. Department of Justice opposed a "recognition" standard as "such a criterion is likely to create a nearly insurmountable barrier to de novo entry into the market for NRSRO services." Comments of the U.S. Department of Justice submitted to the Commission, dated March 6, 1998, in the matter of File No. S7-33-97, Proposed Amendments to Rule 15c3-1 under the Securities Exchange Act of 1934.