The Bond Market Association

July 28, 2003

Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609

Re: Concept Release: Rating Agencies and the Use of Credit Ratings
Under the Federal Securities Laws (File No. S7-12-03)

Dear Mr. Katz:

The Bond Market Association1 (the "Association") welcomes the opportunity to comment on the above-captioned concept release (the "Concept Release") issued by the Securities and Exchange Commission (the "Commission").

I. Executive Summary.

Credit rating agencies play a critical role in the efficient functioning of the fixed income markets. In addition, they have a significant function under a number of Commission regulations, including the net capital rule applicable to broker-dealers. Although the Concept Release and the Commission's January 2003 Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets note a number of issues relating to credit rating agencies and their operations that may be of concern to the fixed income markets, as a general matter the Association believes that the current system of oversight of credit rating agencies functions reasonably well. As a result, the Association believes that the nationally recognized statistical rating organization ("NRSRO") designation should be retained in substantially its current form and that significant additional regulatory oversight of credit rating agencies is unwarranted. In particular, the Association is concerned that adoption of rules that mandate or specify particular rating practices or procedures could adversely affect the quality and diversity of rating information available to market participants. Moreover, rules that subject individual rating determinations to Commission review could chill communication between issuers and rating agencies and also adversely affect the quality of rating information.

The Association does believe, however, that given the important role played by credit rating agencies in the fixed income markets and for regulatory purposes, the process by which agencies are designated as NRSROs for purposes of the Commission's rules should be made more transparent. In this regard, the Association recommends that the Commission adopt regulations that specify the procedures and requirements for NRSRO designation, rather than continuing to rely on designation by staff no-action letters. In addition, the Association believes that the Commission should encourage competition in the credit rating industry, consistent with the goal of maintaining rigorous standards in the industry, by applying the designation standards in a way that will facilitate designation of new NRSROs, including NRSROs that rate securities only in a single or a limited number of market sectors or in non-U.S. jurisdictions.2

II. General Considerations.

In assessing the appropriate level of Commission oversight of credit rating agencies, it is useful to consider the critical role that credit rating agencies have long played in the efficient functioning of the fixed income markets. Unlike certain factors that affect the value of a credit instrument, such as maturity, yield, call features and priority vis-à-vis other classes of creditors, issuer creditworthiness inherently cannot be measured with precision. Many of the factors that relate to a determination of issuer creditworthiness, including the capability and experience of management, the quality of risk controls, and the ability to adapt to changing market conditions, among others, require a significant degree of subjective assessment. Credit rating agencies, by aggregating factors, both objective and subjective, that form a part of credit standing give market participants an additional source of information that can help to confirm market assessments of credit risk. Because ratings provide a reasoned and categorical assessment of the relative creditworthiness of credit instruments and issuers, it is appropriate that Commission rules permit references to ratings as benchmarks in specific contexts that are sensitive to the relative safety of different investments.

At the same time, it is important to appreciate that credit ratings represent only one information source available to market participants about credit quality. Sell-side and buy-side firms that are active in the fixed income markets conduct their own intensive credit analyses for risk management purposes, including the maintenance of adequate capital, and for purposes of identifying pricing discrepancies in conducting their trading operations. Further, much information is available to the marketplace in the form of research conducted by securities and independent research firms. From the standpoint of major market participants, therefore, ratings do not substitute for the need to carefully monitor the credit of issuers as to which firms have substantial credit exposure, but instead form one part of the mix of information that they use in performing that function.

Ratings issued by the major rating agencies have generally proved to be a reliable source of information for the fixed income markets. The reputational and commercial interests of the agencies provide a strong motivation to maintain the credibility of their ratings. Historically, a variety of studies have demonstrated a consistent and clear correlation between long-term corporate debt ratings and the probability of default.3 There should not, however, be an expectation on the part of regulators or market participants that any rating agency, or ratings system, will act as a perfect evaluator of credit risk or quality. This is true because of the complexity of evaluating the various objective and subjective factors that affect creditworthiness and reflecting them in a single symbolic rating.

In addition, rating agencies should not and cannot be reasonably charged with uncovering and evaluating all possible undisclosed risks or liabilities that might affect credit quality, or with uncovering fraud or other misconduct by issuers. Rating agencies, like other market participants, must be able to rely on the integrity of the audit process to produce financial information that is accurate and complete. Although rating agencies may have access to certain information not contained in public disclosures of issuers pursuant to the exemption from Regulation FD for certain disclosures to credit rating agencies,4 the agencies lack the resources and expertise to conduct an independent audit of all the financial information produced by the issuers they rate and cannot be expected to police in any meaningful way the review conducted and decisions made by accounting professionals.

III. Comments on the Concept Release.

In light of these considerations, the Association generally believes that the Commission should retain the current level of regulatory oversight of credit rating agencies, with some modifications. Specifically, the Commission should (i) retain the current uses of the NRSRO designation under its rules, (ii) improve the transparency of the designation process by adopting a formal application procedure, (iii) clarify the designation criteria to more easily permit certain rating agencies, including those that rate issuers only in certain sectors or jurisdictions, to become NRSROs, and (iv) address ongoing examination and compliance considerations by requiring annual certifications by NRSROs of continued compliance with the applicable designation criteria.

A. Retention of the NRSRO Designation.

The Association believes that the NRSRO designation performs an important function for purposes of the Commission's regulations that cannot easily be replaced or duplicated. Although there may be alternatives to using NRSRO credit ratings in some regulatory contexts, such as permitting the use of internal credit ratings or credit spreads in computing net capital requirements,5 these alternatives may entail significant costs and may not be practical in all situations, or for all firms. Overall, the Association does not believe that there is any single existing replacement or proxy for NRSRO ratings that is as useful as such ratings for all of the functions that such ratings now serve under the Commission's regulations.

For certain of the Commission's regulations, there is no readily apparent substitute for reliance on NRSRO credit ratings. In the context of the exemption from Regulation M for transactions in investment grade debt securities, for example, reliance on external credit ratings is necessary for the exemption to apply uniformly for all market participants. Use of an internal ratings-based approach, where different broker-dealers could have different determinations of whether an obligation is investment grade, would not be appropriate. There is similarly no easy substitute for reliance on investment grade ratings in the Form S-3 eligibility criteria for asset-backed issuers. As a general matter, for those regulations where a uniform set of standards across market participants is desirable, reliance on NRSRO credit ratings works particularly well.

In the Association's view, whatever imperfections may exist in the practices of credit rating agencies do not warrant eliminating the use of NRSRO credit ratings for purposes of the Commission regulations that currently rely on such ratings.

B. NRSRO Designation Process.

If the Commission determines to retain the use of NRSRO ratings for purposes of its regulations, the Association generally supports the suggestions in the Concept Release (and in the Commission's 1997 proposed rule regarding NRSRO designation)6 for improving the transparency of the designation process. Improving transparency would make the ratings process more understandable to the investing public and facilitate the designation of additional NRSROs, which could beneficially increase competition among rating agencies and thereby improve the quality and availability of rating information.

In this regard, given the importance of credit rating agencies to the investing public as well as for regulatory purposes, the Association would support a more formal application process established pursuant to Commission regulations, rather than the current no-action approach. Preferably, designation of NRSROs should occur through Commission action (or by staff decision with a process of appeal to the Commission). Specifically, the Association recommends as follows:

  • The Commission should adopt a specific form of application that specifies the information to be provided by the applicant. This will help ensure that the application process is standardized, and that each applicant is required to provide information of the same type and scope.

  • Applications (and related exhibits) should be made public at the time they are acted upon by the Commission (or its staff). In light of the importance of NRSRO designation to the fixed income markets, the Commission should invite public comment on NRSRO applications. As with other application procedures, an applicant likely to receive an adverse determination could be permitted to withdraw the application without public disclosure prior to the beginning of any public comment period. The Commission could permit, in accordance with the Freedom of Information Act and related Commission rules, confidential treatment of certain information provided by an applicant if necessary to protect legitimate confidential commercial or financial information of the applicant.

  • The decision by the Commission (or its staff) to grant or deny an application should explicitly set forth the reasons for the decision by reference to the requirements in the Commission's regulations and the information provided by the applicant. The decision should also fully describe any conditions that are imposed in order to obtain or maintain the NRSRO designation. It is critical to the integrity of the designation process that investors and other interested parties be able to understand the Commission's (or its staff's) reasoning in acting on an application.

  • Existing NRSROs should be required to complete the application process, in order to ensure that all applicants are treated fairly and held to the same standards. To avoid disruptions to the markets, existing NRSROs could remain designated as such pending action by the Commission (or its staff) on their applications, however.

C. NRSRO Designation Criteria.

In its no-action letters granting NRSRO designation, the staff of the Division of Market Regulation has indicated that the most important criterion for obtaining designation is that the rating agency is widely accepted in the United States as an issuer of credible and reliable ratings by the predominant users of securities ratings. The staff has also stated that it reviews the operational capability and reliability of the rating agency, including (1) the organizational structure of the rating agency, (2) its financial resources (to determine, among other factors, whether it is able to operate independently of economic pressures or control by the companies it rates), (3) the size and experience and training of its staff (to determine if it is capable of thoroughly and competently evaluating an issuer's credit), (4) its independence from the companies it rates, (5) its rating procedures (to determine whether it has systematic procedures designed to produce credible and accurate ratings), and (6) whether it has internal procedures to prevent the misuse of nonpublic information and whether those procedures are followed.7

The Association generally believes that it is appropriate for the Commission to continue to use criteria along these lines in evaluating applications for NRSRO status. As described above, however, the Association believes that the Commission should implement formal procedures for the application process, and as part of that process adopt regulations setting forth these criteria in more detail.

In addition, the Association believes that the Commission should undertake, in reviewing its designation criteria and application process, to promote competition, consistent with a rigorous application process and prudent application of the Commission's regulatory standards. As noted in the Concept Release, there are currently only four entities designated as NRSROs. Although this situation undoubtedly results in part from market-driven factors like economies of scale and consolidation in the credit rating industry, it may also be affected by past reluctance by the staff to countenance new entrants.8

In this regard, the Association recommends that the Commission revise the current "widely accepted" standard to permit the designation as NRSROs of rating agencies that otherwise satisfy the Commission's criteria but rate securities only in certain market sectors or jurisdictions. For example, an agency that is well established in a foreign jurisdiction may not be widely recognized or accepted in the United States but may still be capable of credibly rating instruments of issuers from that jurisdiction. Rating agencies with expertise in a particular industry sector should also be permitted to be NRSROs for purposes of rating issuers in that sector. For rating agencies whose expertise is limited to a particular sector or jurisdiction, the Commission could limit their NRSRO status to ratings of issuers in that sector or jurisdiction.

In terms of adopting additional designation criteria, the Association would oppose the Commission's mandating particular rating methodologies, practices or procedures as a condition to NRSRO designation. For example, the Commission does not need to, and should not, require minimum due diligence standards and/or the use of a particular rating methodology (e.g., the use of statistical models versus more qualitative models or vice versa). The Commission also should not attempt to specify the process by which individual ratings are assigned or updated. The complex nature of the ratings process, its application to individual companies and the judgments it requires, do not lend themselves to a system of rigorous government oversight. Neither the Commission nor any other government agency is well positioned to evaluate the validity of individual rating decisions based on numerous, and in some cases subjective, factors.

In addition, the federal scheme of securities regulation is designated generally to avoid "merit regulation," or the endorsement or certification of the value or safety of any particular investments, for at least two reasons. First, it is impossible for any one authority to accurately measure, or even to specify a method for accurately measuring, relative investment merits in the context of a constantly changing marketplace. Second, Congress, the Commission and other regulators have made a determination that the markets work most efficiently and provide the maximum common benefit when the merits of individual securities are judged by the countless decisions of individual market participants, subject to legal obligations to disclose material facts and risks. Any attempt by a regulatory authority to mandate or specify the process by which ratings decisions are made would necessarily carry with it a governmental imprimatur that investors might rely upon. It is critical that investors understand that ratings are not infallible, and that a favorable rating is not a guarantee of safety. Excessive government involvement in the rating process might imply a different message that would give investors false comfort which could ultimately undermine rather than reinforce investor confidence.

D. Examination and Oversight.

The Association believes that, consistent with the goal of establishing a more formal application procedure, the Commission should also require an annual certification by each NRSRO that it continues to satisfy the requirements of the Commission's regulations and any other conditions imposed in connection with its NRSRO status.9 On the other hand, the Commission should not, in the Association's view, subject NRSROs to additional ongoing examination or oversight, especially with respect to particular rating methodologies, practices or individual rating determinations. Such examination or oversight could have the effect of limiting issuers' willingness to communicate with rating agencies and thereby adversely affect the quality of rating information.

The Association supports an annual certification on the grounds that in assuring that a rating agency continues to meet the standards that have been set, it is not sufficient to hold out the threat of withdrawing NRSRO designation based on a subsequent determination that the standards are no longer satisfied or conditions have not been met. Annual certification by NRSROs could help ensure that NRSROs themselves conduct a comprehensive ongoing review of their compliance with applicable requirements and conditions. If an NRSRO fails to make the required annual certification, the Commission could, of course, investigate further and, if appropriate, withdraw or suspend its NRSRO designation.

Aside from this type of annual certification, however, the Association does not believe that NRSROs need to be subject to significant additional ongoing examination or oversight. As an initial matter, it is not clear what the purpose would be of additional oversight, beyond that necessary to ensure compliance with the conditions of designation. For the reasons discussed above, the Association does not believe that the Commission should attempt to mandate or specify particular rating methodologies or practices. In addition, the Commission should not involve itself in, or attempt to review, individual rating determinations with respect to particular issuers.

The Association believes that certain recordkeeping requirements, including those related to a rating agency's satisfaction of NRSRO designation criteria, are appropriate, and that the Commission may have reason to examine those records under certain circumstances.10 The Association believes, however, that the Commission should be mindful of the concern that any such recordkeeping or examination requirements could chill communication between issuers and rating agencies and among analysts within a rating agency, and thereby adversely affect the quality of rating information that is available in the marketplace, particularly if the requirements relate to records of confidential communications with issuers or internal discussions as to individual rating decisions and the reasons for those decisions.11

E. Conflicts of Interest.

The Association recognizes that conflicts of interest between rating agencies, the issuers they rate and their subscribers may exist. As a result, it may be appropriate to require, as the current designation criteria do to some extent, that a rating agency have policies and procedures to address potential conflicts of interest, including potential issuer and subscriber influence and misuse of nonpublic information, as part of the NRSRO designation criteria.

Nonetheless, the Association believes that the Commission should not mandate specific approaches or methods for addressing conflicts of interests, such as firewalls, compensation structures, revenue or asset tests or, in particular, restrictions on non-rating activities of NRSROs, such as advisory services. Such services in particular are beneficial to many issuers and market participants, and the Association is aware of no evidence that such services present a significant conflict of interest warranting restriction. Subject to a general requirement to demonstrate, as part of the application process, that the firm maintains appropriate policies to address conflicts of interests, rating agencies should have some flexibility in terms of the approaches taken, in light of the particular characteristics of their business and operations. This approach will also help facilitate the designation of new rating agencies as NRSROs, as procedures appropriate for large, broad-based rating agencies may not be suited to newer agencies or agencies rating in only limited sectors or jurisdictions.

F. Anticompetitive, Abusive and Unfair Practices.

The Association notes that certain allegations have been made as to anticompetitive, abusive or unfair practices by credit rating agencies. As a general matter, the Association does not believe that these issues are appropriately addressed by a Commission rulemaking at this time.12 The Association notes in this regard that many of these allegations concern abuse of market position, tying and other practices that may be subject to applicable antitrust law. In addition, the Association believes that increasing competition among credit rating agencies, such as by facilitating designation of new NRSROs, will help reduce the risk of anticompetitive practices.

* * *

The Association and its members appreciate the opportunity to comment on the Concept Release. If the Commission determines to proceed with a rulemaking, the Association would be pleased to continue to work with the Commission and its staff and other market participants to address the issues raised by the Concept Release.

Please feel free to contact the undersigned or Paul Saltzman at 646.637.9200 with any questions.

Respectfully submitted,

John M. Ramsay
Senior Vice President and Regulatory Counsel

cc: William H. Donaldson, Chairman
Cynthia A. Glassman, Commissioner
Harvey J. Goldschmid, Commissioner
Paul S. Atkins, Commissioner
Roel C. Campos, Commissioner
Paul F. Roye, Director, Division of Investment Management
Alan L. Beller, Director, Division of Corporation Finance
Stephen M. Cutler, Director, Division of Enforcement
Annette L. Nazareth, Director, Division of Market Regulation
Giovanni P. Prezioso, General Counsel

1 The Association represents securities firms and banks that underwrite, distribute, and trade in fixed income securities, both domestically and internationally. More information about the Association is available on its website, The Association's committees that have been involved in providing these comments include the Legal Advisory Committees of the Corporate Credit Markets Division, Funding Division, Municipal Division, MBS/ABS Division, and Government Division, and various cross-market committees of the Association.
2 The Association accordingly views the recent recognition of Dominion Bond Rating Service Limited as an NRSRO as a positive development in this regard. See Dominion Bond Rating Service Limited (Feb. 24, 2003).
3 See generally Credit Ratings and Complementary Sources of Credit Quality Information, Basel Committee on Banking Supervision Working Papers (August 2000).
4 The Association strongly supports maintaining this exemption. Eliminating it would provide a substantial disincentive to rating agencies to "dig beneath the numbers," and thereby might sharply limit the value added by rating agencies to the fixed income markets. The Association also opposes the adoption of rules that would prohibit or limit the ability of NRSRO analysts to discuss rating actions with subscribers. Existing legal and contractual requirements, together with reputational considerations and reasonable conditions imposed by the Commission as part of the designation process, are sufficient incentive for NRSROs to manage any confidentiality and conflict of interest concerns arising from such discussions.
5 The Association encourages the Commission to continue to explore the possibility of allowing broker-dealers to use internal risk models for net capital purposes, along the lines of the internal ratings-based approach being developed under the revised Basel bank capital accord. We note, however, that mandating such an approach in lieu of the current approach based on NRSRO ratings might impose significant additional costs on some broker-dealers.
6 Capital Requirements for Brokers or Dealers under the Securities Exchange Act of 1934, Release No. 34-39457, 62 Fed. Reg. 68018 (Dec. 30, 1997).
7 See, e.g., Dominion Bond Rating Service Limited (Feb. 24, 2003). The Association notes that the Commission's 1997 rule proposal set forth a similar list of criteria and would in addition have required each NRSRO to be registered as an investment adviser under the Investment Advisers Act of 1940 (the "Advisers Act").
8 See, e.g., Lawrence J. White, Stern School of Business, New York University, "The Credit Rating Industry: An Industrial Organization Analysis" (2001).
9 The Association does not, however, believe that annual certifications need to be subject to public comment.
10 The Association notes, however, that the Commission may as a practical matter already have access to such information pursuant to the recordkeeping requirements for investment advisers under Investment Advisers Act Rule 204-2.
11 Of course, in the case of specific Commission investigations of fraud or other misconduct, rating agencies would generally be subject to the Commission's investigative authority in accordance with applicable law to the same extent as other persons.
12 With respect to the specific issue of unsolicited ratings, the Association does not believe that the Commission needs to restrict the practice, although in the interest of promoting transparency of the rating process it would be appropriate to require rating agencies to disclose the fact that a rating is unsolicited or issued without discussions with the management of the issuer. With respect to allegations of anticompetitive conduct generally (as well as conflicts of interest), specific concerns would be appropriately raised as part of the public comment process following submission of an application.