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November 10, 2002

Jonathan G. Katz, Secretary
United States Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Re.: November 15, 2002 Hearing on Credit Rating Agencies (File Number 4-467)

The SEC describes itself as the "Investor's Advocate" with the following statement from its web site, "The primary mission of the U.S. Securities and Exchange Commission (SEC) is to protect investors and maintain the integrity of the securities markets."

Since the SEC has elected to discharge this mission by awarding recognition to certain rating agencies (NRSRO's, in SEC parlance, which is currently limited to S&P, Moody's and Fitch), the issue of investor protection must therefore be addressed in terms of NRSRO performance. Such performance has fallen far short of an adequate level in protecting investors as witnessed by the following failures:

  • Enron was rated investment grade by the NRSRO's four days before bankruptcy;

  • The California utilities were rated "A-" two weeks before defaulting;

  • WorldCom was rated investment grade three months before filing for bankruptcy;

  • Global Crossing was rated investment grade in March 2002 and defaulted on loans in July 2002;

  • AT&T Canada was rated investment grade in early February 2002 and defaulted in September 2002; and

  • ABB was rated "A2" by Moody's as of March 14th 2002 and was rated "Ba2", negative watch as of October 31, 2002. Similarly, S&P rated ABB at "A+" as of March 14th, 2002 and "BBB-", negative watch as of November 5 th 2002.

An additional indication of the failure of the current NRSRO's was a survey by H. Kent Baker and Sattar A. Mansi published in Table 9 of their June 18, 2001 article Assessing Credit Rating Agencies by Bond Issuers and Institutional Investors which indicated that only 29% of bond fund managers believe the NRSRO's updated their ratings in a timely manner. Since other firms succeeded in providing investors with warning, we believe the failures can be attributed to (i) a conflict in interest, and (ii) the lack of competition.

Regarding conflicts, we note a pattern similar to the Wall Street equity analysts since the current NRSRO's are supported mainly by the issuers (according to Moody's 10K, it obtains 87% of its compensation from issuers) and therefore have substantial conflicts of interests with investors. The adage "one cannot serve two masters" applies to the ratings field; a firm can either support issuers or investors. The conflict appears to be particularly acute for large important issues such as the California utilities, Enron, WorldCom, and currently, the auto firms. In these cases investors desperately need guidance from credit rating firms, but often do not get it because of pressure from issuers, investment banks, commercial banks and in some cases, security exchange officials (see the October 8, 2002 Report of the Staff to the Senate Committee on Governmental Affairs, Financial Oversight of Enron: the SEC and Private-Sector Watchdogs, page 113). Although argument can be made that any one issue represents a relatively small share of the rating firm's revenue base, the reality is that investors have not been protected. Revenues produced by Jack Grubman and Henry Blodget were likewise only a small portion of CitiGroup's and Merrill's revenues.

Regarding the lack of competition, the number of NRSRO's has declined from six three years ago to three currently. In the case of most US corporate ratings and an increasing number of structured finance transactions, S&P and Moody's are the only firms used. The industry could more accurately be described as a "partner monopoly", a term used by U.S. Department of Justice personnel. A partner monopoly differs from an oligopoly in the sense that the two firms share the market whereby the gain in revenues by one firm does not reduce the revenues of the second firm. Since two ratings are normally needed for the issuance of bonds, the gains of Moody's do not come at the expense of S&P and vice versa.

The problems associated with the lack of competition and conflicts of interest go beyond the Enron, Global Crossing and California utility failures. A letter (available upon request) from a senior executive at a brokerage firm whose clients were defrauded by Allied Signal which requested that the rating firms withdraw their rating of an issue of Grimes, an Allied subsidiary, so that investors holding the bonds would be forced to sell (because of the lack of a credit rating), thereby enabling Allied Signal to repurchase the bonds at a lower price. The response given by the rating firms for not rating the bonds was "an official of Allied ... told them they [Allied] would be very unhappy if that agency rated Grimes. That rating agency said candidly that Allied was a source of rating income and that they would not jeopardize the relationship". In another variation of the abuses of the NRSRO designation and anti-competitive practices, Moody's in the 1990's assigned an intentionally low rating to some municipal issues which refused to retain Moody's for its ratings services. In these and most other cases, Moody's successfully used the First Amendment protection, arguing that its ratings were merely its opinions and that it was exercising its freedom of speech. Individuals have the right to free speech, but when monopoly firm employs anti-competitive practices to extend its monopoly, the SEC needs to revoke its NRSRO designation. Because of the dominance of S&P and Moody's it is rare to find parties willing to file a public complaint against them.


Employees, pensioners, and investors were badly hurt by the failure of Enron, Global Crossing, the California utilities and other companies; more unnecessary pain can be expected unless and until changes are made in the seriously flawed system. We recommend the following changes:

  1. Recognize some non-conflicted firms which have warned investors - The hearings are an attempt to prevent future Enron and WorldCom failures. The best way is to recognize as NRSRO's rating firms that do not have a conflict of interest with investors and which have succeeded in providing warnings to investors.

  2. Prohibit issuer compensation - just as equity research practices were not corrupted until the emergence of large issuer-based compensation, in the form of investment banking fees, existing NRSRO's prior to 1970 obtained most of their compensation from investors. NRSRO's argue that the copy machine made the old business model less attractive because of the ease of distributing ratings. Our response is that there are a number of firms that have thrived without issuer compensation; Sanford Bernstein and Prudential are prime examples on the equity side, and Egan-Jones and Mikuni are examples on the credit rating side.

  3. Prohibit involvement with rated firms and dealers - Moody's Chairman, Clifford Alexander, served as a director of MCI from 1982 until 1998 and of WorldCom from 1998 until June 2001; the Company filed for bankruptcy in July 2002 making it the largest bankruptcy in US history. Moody's President Clifford Alexander should be prohibited from serving on the board of the National Association of Security Dealers, which represents security dealers. Dealers' interests are not parallel to investors' interests.

  4. Remove the exclusion from Regulation FD - rating firms are essentially private research firms and therefore should not be provided with any special treatment. Information gathered by the monopolistic rating firms for the rating triggers was subsequently distributed only to clients paying for the research portion of the NRSRO's service.

  5. Separate ratings from consulting - just as accountants were compromised by their consulting assignments, ratings firms have similar issues. A number of independent, non-conflicted firms offer this service.

  6. Prohibit the use of rating triggers - affording another example of putting issuers' interests ahead of investors', the current NRSRO's were reluctant to downgrade firms because of the fear of setting off rating triggers.

  7. Prohibit the usage of "independent" - all the current NRSRO's obtain the majority of their compensation from issuers and therefore should not mislead investors by describing themselves as independent.

  8. Police monopolistic practices - a fair amount of controversy has been generated by Moody's notching (cutting) Fitch's ratings by up to five or six notches in the structured finance area in an attempt to extend its reach. Similarly, it appears as though the large NRSRO's have discouraged major news organizations from carrying ratings or news generated from competing rating firms.

  9. Prohibit providing "color" to investors - some investors, particularly large investors are given information on analysts' opinions in advance of others.

  10. If the SEC is unable to provide more protection to investors, we recommend that the NRSRO system be dropped. Through security prices, the market has already declared the current NRSRO's to be pathetically slow in their actions; perhaps the government should get out of the business of protecting a few firms and their enormous margins and allow the market to develop.

Comments on Composition of Hearings

We do not believe that investors' interests are adequately represented in the composition of the Hearings on Credit Rating Agencies or that there will be any meaningful change in the non-independent partner monopoly that is the root cause of the failure to warn investors. The majority of the panel is comprised of the current NRSRO's, large security firms, large issuers, large investors (which are capable of doing their own research), associations representing large security firms (the SIA and Bond Market Association) and issuers (the Association for Finance Professionals) and large investors (the Investment Company Institute).  One of the two academics included is conflicted (Schwarcz's research center is supported by S&P and the large security firms).

Conspicuously absent are independent academics who are considered experts in the field such as Larry White of NYU and Frank Partnoy of Washington University, consumer and investor advocates such as the Consumer Federation of America, the Department of Justice and groups that have been hurt by the WorldCom, Enron, Global Crossing and other failures.


Sean J. Egan

W. Bruce Jones

Selected Quotes - Egan-Jones Ratings Co.

New York Times
Gretchen Morgenson (Pulitzer Prize Winner)

July 7, 2002

"Egan-Jones makes a practice of alerting investors to corporate credit problems well before they are acknowledged by management... As early as November 2000, for example, Egan-Jones cut its ratings on WorldCom to the lowest investment-grade level, citing its deteriorating profit margins and credit quality."

Fortune's "Against the Grain"
Herb Greenberg

January 21, 2002

"The best balance-sheet snoops are often way ahead of the pack in finding signs of trouble. Sometimes, however, the big credit-rating firms, Standard & Poor's and Moody's, which get paid by the companies they rate, are slow off the mark--slower, as a rule, than independent bond-rating services like Egan-Jones of Wynnewood, Pa...."We don't have the constraint of trying to keep a company happy," says Egan-Jones President Sean Egan, whose downgrade of Enron to junk beat the big guys by about a month."

Investment Dealers Digest (cover)
Dave Lindorff

August 13, 2001

"It didn't take long for Sean Egan, managing director of Egan-Jones Ratings Co., a small ratings agency outside Philadelphia, to figure out last fall's California power crisis would eventually put the state's utilities in a bind. "We saw a train wreck ahead for these companies," recalls Egan, who says his analysts quickly fired off two reports to clients warning them of the troubles facing the state's two utilities-Pacific Gas & Electric Corp. and Edison International, the parent company of Southern California Edison. On Sept. 27, the firm lowered EIX's rating from A- to BBB-, and PG&E's rating from A to BBB+."

Grant's Interest Rate Observer
Jim Grant

Annual Conference, October 2002

"The big two-and-a-half rating agencies have not exactly covered themselves in glory during the current credit debacles. Sean Egan, co-founder of Egan-Jones Ratings Co. (which saw many disasters coming before they landed in the newspapers), will discuss debacles and opportunities yet over the horizon."


Enron's Senior Unsecured Ratings

  The bold indicates non-investment grade  
  Date   Egan-Jones* S&P Moody's
  4/19/2001   BBB+ BBB+ Baa1
  • 6/27/2001   BBB BBB+ Baa1
      8/15/2001   BBB/ BBB- BBB+ Baa1
      10/16/2001   BBB/ BBB- BBB+ Baa1 (neg.)
      10/23/2001   BBB- BBB+ Baa1 (neg.)
      10/24/2001   BBB-/ BB+ BBB+ Baa1 (neg.)
      10/26/2001   BB+ BBB+ Baa1 (neg.)
      10/29/2001   BB+/ BB BBB+ Baa2 (neg.)
      10/31/2001   BB+/ BB BBB+ Baa2 (neg.)
      11/1/2001   BB BBB (neg.) Baa2 (neg.)
      11/6/2001   BB BBB (neg.) Baa2 (neg.)
      11/7/2001   BB-/ B- BBB (neg.) Baa2 (neg.)
      11/9/2001   BB BBB- (neg.) Baa3 (neg.)
      11/21/2001   BB/ BB- BBB- (neg.) Baa3 (neg.)
      11/26/2001   BB-/ B+ BBB- (neg.) Baa3 (neg.)
      11/28/2001   B+/ B- BBB- (neg.) Baa3 (neg.)
      11/28/2001   C/ D B- B2 (neg.)
      11/29/2001   D B- B2 (neg.)
      11/30/2001   D CC (neg.) B2 (neg.)
      12/3/2001   D D Ca
      * Current and projected ratings  


    WorldCom's Senior Unsecured Ratings

    The bold indicates non-investment grade
    Date Egan-Jones* S&P Moody's Action
    11/1/2000 A- (neg. watch) A- A3 EJR issued neg. watch (A-)
    11/ 3/00 A- (neg. watch) A- (neg. watch) A3 S&P issued a neg. watch (A-)
    11/17/2000 BBB+ (neg. watch) A- (neg. watch) A3 EJR cut A- to BBB+ (neg. watch)
    2/8/2001 BBB A- (neg. watch) A3 EJR cut BBB+ to BBB
    2/27/01 BBB BBB+ A3 S&P cut A- to BBB+
    6/25/2001 BBB- BBB+ A3 EJR cut BBB to BBB-
    7/26/2001 BB+ (neg. watch) BBB+ A3 EJR cut BBB- to BB+ (neg watch)
    1/29/2002 BB (neg. watch) BBB+ A3 EJR cut BB+ to BB (neg watch)
    2/ 7/02 BB- (neg. watch) BBB+ A3 EJR cut BB to BB- (neg watch)
    2/ 7/02 BB- (neg. watch) BBB+ A3 (neg. watch) Moody's issued a neg. watch (A3)
    2/19/2002 B+ BBB+ A3 (neg. watch) EJR cut BB- to B+
    4/12/02 B+ BBB+ (neg. watch) A3 (neg. watch) S&P issued a neg. watch (BBB+)
    4/22/02 B+ BBB A3 (neg. watch) S&P cut BBB+ to BBB
    4/23/02 B BBB A3 (neg. watch) EJR cut B+ to B
    4/23/02 B BBB Baa2 Moody's cut A3 to Baa2
    4/25/2002 B- BBB Baa2 EJR cut B to B-
    5/ 9/02 B- BBB Ba2 Moody's cut Baa2 to Ba2
    5/10/02 B- BB Ba2 S&P cut BBB to BB
    6/14/2002 B- (neg. watch) BB Ba2 EJR issues neg. watch
    6/17/02 B- (neg. watch) B+ Ba2 S&P cut BB to B+
    6/20/02 CCC (neg. watch) B+ Ba2 EJR cut B- to CCC (neg. watch)
    6/20/02 CCC (neg. watch) B+ B1 Moody's cut Ba2 to B1
    6/26/02 D B+ B1 EJR cut CCC to D
    6/26/02 D CCC- B1 S&P cut B+ to CCC-
    6/26/02 D CCC- Ca Moody's cut B1 to Ca
    7/ 1/02 D CC Ca S&P cut CCC- to CC
    7/17/02 D D Ca S&P cut CC to D