July 24, 2003

Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Attention: Jonathan G. Katz, Secretary

Re: File No. S7-12-03: Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws

Ladies and Gentlemen:

This letter is submitted on behalf of the Committee on Securities Regulation of the Association of the Bar of the City of New York (the "Committee") in response to Release Nos. 33-8236, 34-47972 and IC-26066, dated June 4, 2003 (the "Release"). In the Release, the Securities and Exchange Commission (the "Commission") discussed and requested comment on various issues relating to credit rating agencies, including whether credit ratings should continue to be used for regulatory purposes under the federal securities laws, and, if so, the process of determining whose credit ratings should be used, and the level of oversight to apply to such credit rating agencies.

Our Committee is composed of lawyers with diverse perspectives on securities issues, including academics, members of law firms, and in-house counsel at investment banks.

The Commission's focus on rating agencies is timely, but we believe that it should take only limited action. As discussed in more detail below:

  • The Commission should not undertake to regulate the activities of rating agencies, except to the extent reasonably required for the limited uses made under its rules of ratings by "nationally recognized statistical rating organizations" (NRSROs).

  • The Commission should continue to rely on NRSRO ratings in the net capital rules.

  • The Commission should improve the process by which NRSROs are designated.

The Commission does not have a specific statutory mandate to regulate rating agencies, and there are two strong reasons why the Commission should tread lightly in dealing with them. First, as the Release observes, some claim that the core of their business is the expression of opinions in a public forum about matters of considerable public interest, and that this activity is entitled to constitutional protection. While its detailed implications are debatable, this claim is not without justification. Second, the concentration of market power in the ratings industry is problematic as a matter of competition policy.1 Because both the constitutional concern and the competition concern lie outside the area of investor protection that is the Commission's particular public policy responsibility, we believe the Commission has been appropriately circumspect in dealing with rating agencies in the absence of specific congressional direction to do so.

This approach should not change as a result of the lamentable succession of business failures and corporate scandals that have characterized the past two years. Rating agencies are among the many institutions that failed to foresee or prevent these events, and like other institutions they have been justly criticized for their failures.2 But the decision to subject them to greater regulation should be made by Congress, and not by the Commission.

It is true that by allowing broker-dealers to rely on NRSRO ratings to classify their risks for net capital purposes, since 1975 the Commission has in effect offered to grant a kind of limited license to certain rating agencies. Indeed, the operation of the net capital rules requires that there be a minimum number of NRSROs. The NRSRO designation has since been borrowed for other purposes by the Commission itself and by other regulators, leveraging the importance of the designation in the operation of the securities markets. By this indirect path, the Commission has undertaken a limited degree of regulatory responsibility for the ratings industry. The developments of the past few years do not provide convincing arguments that this development was unwise or that it must be reversed, and in any case it would be difficult to do so because reliance on the NRSRO designation has become so widespread.3

There is in any case no pressing need to reconsider the use of NRSRO ratings in the Commission's net capital rules. Capital requirements for financial institutions, including broker-dealers, are obviously a paramount concern of the Commission and other regulators, and they are the focus of several major current regulatory initiatives. Methodologies for classifying risks, including reliance on NRSRO ratings, should be considered in the broader context of those initiatives. They could lead to a decidedly superior method or menu of methods, but until then NRSRO ratings are adequate.

Nor is there a pressing need to reconsider the use of NRSRO ratings in the eligibility criteria for short-form registration under the Securities Act of 1933. The offering process under the Securities Act is a fitting subject for comprehensive reform, but the reliance on NRSRO ratings for short-form registration is one detail among many others. Outside the context of reform of the offering process, there is no particular reason to question this use of ratings. Similarly, the use of NRSRO ratings in Rule 2a-7 under the Investment Company Act of 1940 does not present any particular difficulty. It provides uniform, external standards that play an important role in the market, and there is no ready alternative mechanism. Any change to a more subjective standard could disrupt the market in unpredictable and undesirable ways.

In each of these cases, the only apparent reason to question reliance on NRSRO ratings is that it involves the Commission in designating NRSROs and consequently in at least some evaluation and oversight of at least some rating agencies. As stated above, we believe this development cannot easily be reversed.

The Commission should, however, improve the process for designating NRSROs, which is inadequate in view of its importance to the marketplace. It consists of a private dialogue between a candidate agency and the Commission's staff, based on criteria developed by the staff, and culminating, if the candidate is successful, in a brief no-action letter. The Commission reviewed this situation in the 1990s and correctly concluded that it should be improved. We believe that the Commission should promptly propose a new rule along the general lines of its 1997 proposal. 4 In particular: (1) NRSRO status should be granted or denied by Commission order (whether or not pursuant to an express delegation of authority) in a determination subject to review; (2) it should be based on criteria set forth in a rule of the Commission, adopted after notice and comment; and (3) the process for seeking designation should be clearly described, and it should provide deadlines for Commission action.

The specific details of the designation process, and the substantive criteria to be applied, would be better addressed in the context of a specific proposal than in response to the Release. In general, the substantive criteria for designation should be guided by the principle that the Commission will not regulate NRSROs except to the extent reasonably ancillary to their specific functions under the Commission's rules. Viewed in this light, some of the subjects raised in the Release may be considered beyond the scope of the designation criteria5 while others may be appropriate for Commission consideration.6 The most difficult issue is the criterion of national recognition, on which the Commission staff has historically relied. By deferring to external acceptance of an agency's ratings, the Commission's staff has avoided substantive "merit regulation," but the problem of barriers to entry may require a narrower standard.

* * * * *

As is customary when our Committee submits comments to the Commission, committee member Wayne Carlin of the Commission's enforcement staff did not participate in the preparation of this letter or the decision to submit this letter to the Commission. In addition, this letter does not necessarily reflect the individual views of members of the Committee.

Members of the Committee would be pleased to answer any questions you might have regarding our comments.

Respectfully Submitted,

Charles M. Nathan, Chair
Committee on Securities Regulation

Nicolas Grabar
on behalf of the ad hoc subcommittee members named below

Ad Hoc Subcommittee:

Barbara Alexander
Nicolas Grabar
Cara Londin
James Odell

cc: Annette Nazareth, Director
Division of Market Regulation
Securities and Exchange Commission

1 See Securities and Exchange Commission, Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets 37 (2003) hereinafter the "Section 702 Report" (citing Comments of the United States Dept. of Justice in the Matter of File No. S7-33-97 Proposed Amendments to Rule 15c3-1under the Securities and Exchange Act of 1934 (March 6, 1998)).
2 See, e.g., Senate Committee on Governmental Affairs, Financial Oversight of Enron: The SEC and Private Sector Watchdogs 97-125 (2002).
3 For a review of regulatory provisions that rely upon NRSRO ratings see the Section 702 Report, supra note 2, at 6-8 nn.11-22.
4 Proposed Rule: Capital Requirements for Brokers or Dealers Under the Securities Exchange Act of 1934, Exchange Act Release No. 34-39457 (Dec. 18, 1997), 62 Fed. Reg. 68018 (Dec. 30, 1997).
5 For example, anti-competitive, abusive and unfair practices.
6 For example, conflicts of interest, publication requirements, and mandatory periodic review or certification of compliance with the NRSRO designation criteria.