Amy Lancellotta
Senior Counsel, Investment Company Institute
for the
SEC Hearings on Issues Relating to Credit Rating Agencies
November 21, 2002

I. Introduction

On behalf of the Investment Company Institute,1 I am pleased to submit this statement and to participate in the hearings of the Securities and Exchange Commission (the "Commission") on issues relating to credit rating agencies and their role in the operation of the securities markets.

The Institute commends the Commission for holding these hearings. We believe they will provide a better understanding of the role of credit rating agencies in our nation's securities markets and will assist in evaluating the adequacy of existing regulation of those agencies. The credit ratings published by rating agencies play a significant role in the investment decisions of both institutional and individual investors. The Commission and other regulatory agencies also rely upon these ratings as assessments of investment risk for regulatory purposes.

The Institute has historically commented on the importance of the credit rating agencies and expressed interest in enhancing the regulation governing their activities.2 It is our view that maintaining the integrity and quality of the credit ratings is essential to investor confidence and to the proper functioning of our capital markets. To accomplish this, we recommend that the Commission reevaluate the current regulatory regime for rating agencies, which relies on self-policing and the general application of the Investment Advisers Act of 1940 (the "Advisers Act"). We believe that this regime can be enhanced in several ways so as to reinforce the integrity of the markets and to better protect investors. Accordingly, we recommend that the Commission consider adopting the following regulatory improvements:

  • a new regime of vigorous and continuing Commission oversight of the credit rating agencies;

  • public disclosure of the resources, standards, procedures and policies employed by the agencies in their rating process;

  • a new public comment and review process regarding the agencies' performance, standards, and methodologies; and

  • legal accountability.

II. The Current Role and Regulation of NRSROs

The capital markets and investors have been relying on the ratings of the credit rating agencies for approximately a century. In 1975, the Commission developed the concept of a "nationally recognized statistical rating organization" ("NRSRO") to designate the rating agencies that satisfy certain minimal standards in order to warrant the Commission's reliance on them for regulatory purposes. Since then, regulatory reliance on the role of the NRSROs has increased substantially. The Commission relies upon NRSRO credit ratings to determine charges against the net capital of broker-dealers on different grades of debt securities under Rule 15c3-1 under the Securities Exchange Act of 1934 (the "Exchange Act") and to measure the credit risk of short-term instruments in the regulation of money market funds under Rule 2a-7 under the Investment Company Act of 1940 (the "1940 Act").3 Issuers of certain debt securities that receive an investment grade rating from an NRSRO are entitled to register under the Securities Act of 1933 (the "Securities Act") on the shorter Form S-3. Banking and other regulators similarly rely upon NRSRO credit ratings to protect the capital of financial institutions. Thus, many regulated financial institutions can only purchase certain types of securities if they have received an investment grade rating from an NRSRO.

The Commission also relies, inappropriately in the view of the Institute, upon NRSRO ratings for purposes beyond assessment of credit risk. Rule 3a-7 under the 1940 Act provides an exemption from substantive regulation under that Act for certain issuers of asset-backed securities that have received an investment grade rating from an NRSRO. The rule thus extends the NRSROs' role to determine what level of disclosure and other protections investors are entitled to receive. Moreover, as the Institute previously has noted, the Rule 3a-7 exemption gives the NRSROs an important role in setting industry-wide standards for structured obligations because, for many types of such obligations, issues of structure and credit quality are inexorably intertwined.4 If a mutual fund disagrees with an NRSRO's credit analysis for a particular security or issuer, it can simply avoid that security or issuer. However, if a fund disagrees with an NRSRO's evaluation of structural risk, frequently the only way to avoid the risk may be to exclude from investment whole categories of instruments.

A rating agency is initially designated as an NRSRO by the Commission staff upon a review of its operations, position in the marketplace and other criteria, particularly national recognition of the agency as an issuer of credible and reliable ratings.5 If the staff is satisfied on the basis of its review that the rating agency qualifies as an NRSRO for regulatory purposes, the staff issues a no-action letter that allows broker-dealers and others to rely upon the ratings issued by the agency. Although the designation is intended largely to reflect the view of the marketplace as to credibility, it operates as a seal of approval by a federal regulatory agency. The no-action letter requires that the NRSRO notify the Commission if it experiences material changes that may affect its ability to continue to meet any of the requisite criteria. Insofar as the Institute is aware, no NRSRO has ever provided the Commission with any such notification. Because credit ratings entail the conveyance of a form of investment advice, the Commission staff also requires the rating agencies to register as investment advisers under the Advisers Act.

III. Recommendations for Regulatory Improvements

In light of increased investor and Commission reliance upon NRSROs, the Commission should give serious consideration to strengthening regulatory controls over NRSROs in at least four ways.

1. Commission oversight of NRSROs should be improved.

In view of investors' and the Commission's increasing reliance upon the NRSROs, the Commission's continuing oversight over NRSROs should be enhanced. As noted above, the Commission staff, in assessing whether to designate a rating agency as an NRSRO, reviews a variety of different factors, including financial resources, staff size, experience and training, independence, rating procedures and internal controls over misuse of nonpublic information. Once a rating agency has been designated an NRSRO, it is only required to notify the Commission when it experiences material changes that may affect its ability to meet any of these criteria. However, organizations such as rating agencies are not static and are constantly changing their business, their resources, procedures, and policies. Moreover, given the enormous financial impact that a loss of NRSRO designation would have on a rating agency, it is unrealistic to premise regulation on self-policing and self-reporting.

For these reasons, the Commission should exercise examination authority to provide much more vigorous periodic oversight over the NRSROs' activities. In particular, the Commission should more vigorously monitor compliance with the criteria it employs in the initial designation of an NRSRO. To accomplish this, the Commission staff should schedule more frequent examinations of credit rating agencies: the current examination schedule is every five years, which is the same schedule followed for the smallest advisers subject to the Commission's jurisdiction under the Advisers Act. The examiners should focus on whether the agencies have the necessary national recognition, staffing, resources, structure, internal procedures and issuer contacts to serve as NRSROs.

2. Transparency and disclosure should be improved.

Because of investor and Commission reliance upon the NRSROs' ratings, there should be greater transparency of their operations. Toward this end, the Commission should consider requiring NRSROs to disclose various types of information. The NRSROs should disclose their policies and procedures addressing conflicts of interest to investors and to the regulators that rely upon the objectivity of their ratings. They should also periodically disclose information necessary for investors and the regulators to evaluate whether they have the necessary national recognition, staffing, resources, structure, internal procedures and issuer contacts to serve as NRSROs. Given their unique role, it also would be useful to require that NRSROs disclose certain general and structural elements of their operations. For instance, they might be required to disclose the methodologies used to evaluate the material risks involved with types of financial instruments and the industry-wide standards that the NRSROs effectively set for structured obligations.

For this purpose, the Commission should consider adopting for NRSROs a specialized form, which would require periodic disclosure of the items noted above. Such public disclosure would allow investors and regulators a continuous opportunity to appraise the NRSROs' independence, their capabilities as NRSROs and their unique operations, and it would serve as an effective mechanism for enforcing continued compliance with the criteria considered by the Commission staff in its initial designation process.

3. A public comment and review process should be established.

The Commission should also consider establishing for NRSROs a public comment and review process on a periodic basis (such as every two years) regarding the NRSROs' performance under the Commission's designation criteria. Such a process could be modeled on the FCC broadcast license renewal process, under which licensees must periodically reapply and the FCC solicits public comment on the licensees' performance.6 The Commission process also could allow investors to comment publicly upon the NRSROs' risk evaluation methodologies and the industry-wide standards that the NRSROs effectively set for structured obligations. The staff could then also examine the NRSROs' responsiveness to these comments. If the NRSROs are not sufficiently responsive in particular instances, the Commission should consider limiting specific regulatory reliance upon such ratings. For example, the Commission might consider amending Rule 3a-7 if the NRSROs do not respond adequately to public comments regarding standards for structured obligations.

4. NRSROs should be legally accountable for their ratings.

The Commission has relieved NRSROs from the accountability that would otherwise apply under the federal securities laws: it has exempted NRSROs from expert liability under Section 11 of the Securities Act if their ratings appear in a prospectus for a public offering of a security registered under that Act. As a result, issuers do not have to obtain consents from NRSROs before publishing their ratings and NRSROs are exempt from Section 11 liability if their ratings are included in a registration statement. The exemption of NRSROs from the normal liability provisions of Section 11 of the Securities Act means that NRSROs are not held to a negligence standard of care. The rating agencies also maintain that they are members of the "media" that are providing their "opinions," and thus claim that they can only be liable if their conduct can be said to have been "reckless."7 As a result, the exemption from expert liability lessens the incentives of NRSROs to issue reliable securities ratings.

The NRSROs' exemption from Section 11 liability represents a departure from the normal requirement that an expert's opinion may be published in a registration statement only with the expert's consent and if the expert is liable to investors for negligently misleading opinions. In light of the reliance that investors and the Commission place upon the NRSROs, the Institute believes that the Commission should consider rescinding the NRSROs' exemption from expert liability.

* * *

To implement the above recommendations, the Commission should evaluate its existing regulatory authority. Should that regulatory authority be insufficient to impose a more effective regulatory structure on NRSROs, the Commission should consider seeking such authority from the Congress.

1 The Investment Company Institute is the national association of the American investment company industry. Its membership includes 8,949 open-end investment companies ("mutual funds"), 527 closed-end investment companies and 6 sponsors of investment unit trusts. Its mutual fund members have assets of about $6.045 trillion accounting for approximately 95% of total industry assets, and have over 90.2 million individual shareholders.
2 See Comments of the Investment Company Institute on SEC Proposed Definition of Nationally Recognized Statistical Rating Organizations (File No. S7-33-97) (Mar. 2, 1998) ("ICI Comment Letter"); Comments of the Investment Company Institute on the SEC Concept Release Concerning Nationally Recognized Statistical Rating Organizations (File No. S7-23-94) and Proposed Rules Concerning Disclosure of Securities Ratings (File No. S7-24-94) (Dec. 6, 1994).
3 The term "NRSRO" was originally adopted by the Commission in 1975 solely for the purposes of Rule 15c3-1. See Adoption of Amendments to Rule 15c3-1 and Adoption of Alternative Capital Requirement for Certain Brokers and Dealers, Exchange Act Release No. 11497 (June 26, 1975).
4 ICI Comment Letter at 5.
5 The SEC staff also reviews the operational capability and reliability of each rating agency as part of the NRSRO designation process. This assessment includes: (1) the organizational structure of the rating agency; (2) the rating agency's financial resources (to determine, among other things, whether it is able to operate independently of economic pressures or control from the companies it rates); (3) the size and experience and training of the rating agency's staff (to determine if the entity is capable of thoroughly and competently evaluating an issuer's credit); (4) the rating agency's independence from the companies it rates; (5) the rating agency's rating procedures (to determine whether it has systematic procedures designed to produce credible and accurate ratings); and (6) whether the rating organization has internal procedures to prevent the misuse of nonpublic information and whether those procedures are followed. Rating the Raters: Enron and the Credit Rating Agencies: Hearing Before Senate Comm. On Governmental Affairs, 107th Cong. 2d Sess. 3, 133 (Mar. 20, 2002) (statement of Commissioner Isaac C. Hunt, Jr.).
6 See ICI Comment Letter at 5.
7 See, e.g., First Equity Corporation of Florida v. Standard & Poor's Corporation, 869 F.2d 175 (2d Cir. 1989).