Cantwell & Company

July 22, 2003

Subject: S7-12-03


Cantwell & Company is pleased to submit its comments regarding the concept release on credit rating agencies.

We are independent advisors in the area of credit ratings and have recently begun publishing a subscription based newsletter on credit ratings.


Joseph E. Cantwell

Response to SEC Concept Release: Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws:

Question 1: Should the Commission eliminate the NRSRO designation from Commission rules?

Answer 1: No. This assumes that the Commission wants to have some standard for this type of activity. If no standard is anticipated, then most of the following questions are irrelevant.

Question 2: If so, what alternatives could be adopted to meet the regulatory objectives of the Commission rules that currently incorporate the NRSRO designation? What are their respective strengths and weaknesses?

Answer 2: The first step is to define more clearly the regulatory objectives.

Question 3: Specifically, what are the advantages and disadvantages of allowing broker-dealers to use internally-developed credit ratings to determine capital charges under the Net Capital Rule? Is it appropriate to require strict firewalls between the broker-dealer employees who develop internal credit ratings and those responsible for revenue production? Should a broker-dealer be required to obtain regulatory approval of its credit rating procedures and rating categories before it could use internal credit ratings for calculating capital charges? If so, what factors should the Commission review in determining whether to grant such approval? If the Commission substitutes internal credit ratings for the NRSRO designation in the Net Capital Rule, what would be the impact on broker-dealers, including small broker-dealers, and what costs would be associated with this change? If there would be an inordinate financial impact on small broker-dealers, are there market-based solutions that could reduce the compliance costs for them? For example, should the Commission permit large broker-dealers to sell their internal credit ratings to small broker-dealers for these purposes? If so, would this help to provide a more competitive marketplace for credit ratings? To what extent should the Commission exercise additional regulatory oversight of this activity (e.g., to control potential conflicts of interest)?

Answer 3: In theory, there is no reason why three brokers wouldn't independently come up with three different but similar credit ratings (e.g. BBB, BBB+ and A-). Assuming different interpretations of the same standards, this could be not only reasonable but also justified within each respective organization.

Furthermore, experience has taught us that broker-dealers will be hard pressed to maintain the independence of the internal credit ratings. A lower rating translates into a higher capital allocation which reduces overall business activity. The net result of allowing only the brokers to determine the ratings would be chaos.

Question 4: What are the advantages and disadvantages of allowing broker-dealers to use credit spreads to determine capital charges under the Net Capital Rule and/or other Commission rules? How could capital charges be determined using credit spreads? For example, could the Commission base capital charges on the yield differential between particular debt securities and U.S. Treasury securities of comparable maturity, such that a larger differential results in a larger haircut? How could credit spreads be determined for newly-issued, thinly-traded, or privately-issued securities? Or for variable rate and other short-term synthetic securities held by money market funds? Are there readily available public sources of information sufficient to calculate credit spreads on domestic and foreign debt securities? Are there other model-based statistical scoring systems and/or market-based alternatives that would be viable alternatives to NRSRO ratings?

Answer 4: Credit spreads are a function of many variables. While credit risk may be the most important, it is not the sole determinant of credit spread. As the question correctly supposes, there are other variables at work. A "newly issued, thinly traded, privately placed" security could trade a dramatically different credit spreads versus a "seasoned, widely traded, registered" bond of the same issuer.

Credit spreads are furthermore subjective in nature since the "spread" on a given security would have to be estimated if the security was not actively or recently traded.

Question 5: What are the advantages and disadvantages of requiring the SROs to set appropriate standards for broker-dealers to use in determining rating categories for net capital purposes? What form might these standards take?

Answer 5: The NRSRO's have typically been very reluctant to set standards.

Question 6: What are the advantages and disadvantages of eliminating the "objective test" from Rule 2a-7, and relying solely on the "subjective test" - the credit analysis performed by the adviser to the money market fund - for the purposes of determining asset quality?

Answer 6: Relying solely on a "subjective" test would be ridiculous. If the advisor wanted to be re-hired, there would be no incentive for him/her to render a conservative valuation.

Question 7: What are the advantages and disadvantages of relying upon specified investor sophistication, large size denomination, or asset and structure experience criteria for purposes of determining Form S-3 eligibility? Should the Commission explore these possibilities in more depth? If so, what specific criteria should be considered?

Answer 7: Larger issues are being pushed by the market toward fuller disclosure. Leave these rules unchanged.

Question 8: Are there alternatives other than those discussed above that might be better substitutes for the NRSRO designation in particular Commission rules?

Answer 8: None are obvious.

Question 9: If the Commission discontinued using the NRSRO designation, should an entity other than the Commission recognize NRSROs for uses other than Commission rules? If another entity, which entity? How would the transition from the Commission to that entity take place?

Answer 9: We see no useful purpose for another entity to institute the NRSRO or equivalent designation.

Question 10: If, on the other hand, the Commission should continue to use the NRSRO designation in some Commission rules, could that designation be eliminated from other rules? If so, which rules?

Answer 10: Keep the NRSRO designation in those instances where it facilitates the exchange of information between an issuer and the NRSRO (i.e. there is no required public disclosure of the information provided to the NRSRO). If the market is allowed to determine which entities qualify as NRSROs, there are few other reasons to keep the designation.

Question 11: Are the criteria currently used by Commission staff to determine whether a credit rating agency qualifies as an NRSRO appropriate? If not, what are the appropriate criteria? How should a determination be made as to whether a credit rating agency has met each criterion?

Answer 11: The fact that we were until recently there were only three rating agencies with the NRSRO designation leads to the conclusion that criteria are and have been too rigorous.

Question 12: Is it appropriate to condition NRSRO recognition on a rating agency being widely accepted as an issuer of credible and reliable ratings by the predominant users of securities ratings in the United States (e.g., underwriters, dealers, banks, insurance companies, mutual funds, issuers)? Would this general acceptance be verifiable through the examples set forth above (e.g., requiring verification through attestations from, and interviews with, authorized officers of users of securities ratings, as well as using statistical data to demonstrate market reliance on an applicant's ratings)? As a more objective way of evidencing market reliance and credibility, should NRSRO recognition be conditioned on a credit rating agency documenting that it has been retained to rate securities issued by a broad group of well-capitalized firms?

Answer 12: Allowing the users of the ratings (i.e. investors) to determine which organization qualifies for NRSRO status makes good sense. A qualitative test could be established for designation for inclusion and a less rigorous test for maintenance of the designation.

Aside from the potential cost, there is no disadvantage to the user in having more recognized rating agencies. Assuming that a particular agency passes a "quality test", there should be no requirement for it to rate a broad spectrum of companies in order to quality for NRSRO status.

Question 13: Should the Commission condition NRSRO recognition on a rating agency developing and implementing procedures reasonably designed to ensure credible, reliable, and current ratings? At a minimum, should each NRSRO have rating procedures designed to ensure that a similar analysis is conducted for similarly situated issuers and that current information is used in the rating agency's analysis? What minimum standards should the Commission use to determine whether the agency's ratings are current? Should each NRSRO use uniform rating symbols, as a means of reducing the risk of marketplace confusion? When reviewing a rating agency's procedures for obtaining information on which to base a rating action, should the Commission establish minimum due diligence requirements for rating agencies? How could these minimum requirements be developed? By the Commission? By the industry, with Commission oversight?

Answer 13: The results are more important than the process. Rating agencies which deliver consistently good results will most likely have good internal procedures which will promote the goals implied in these questions (i.e. credible, reliable and current). The rating process is one of evaluation, not disclosure.

Question 14: Should the extent of contacts with the management of issuers (including access to senior level management of issuers) be a criterion used to determine NRSRO status? Should the Commission limit the credit ratings that can be used for regulatory purposes to credit ratings that include access to senior management of an issuer? If so, why?

Answer 14: To require contact with senior management as a rating criteria would destroy the entire process. Corporate management would be less inclined to talk to the agency with the lowest ratings. Rating fees could quickly become a negotiating tool.

Question 15: To the extent a credit rating agency uses computerized statistical models, what factors should be used to review the models? Could a credit rating agency that solely uses a computerized statistical model and no other qualitative inputs qualify as an NRSRO?

Answer 15: The computer models are proprietary and should remain that way. At this point in time, the models probably calculate too many ratios and percentages. The key is to interpret the results.

If a credit rating agency achieves consistently good analytical results, why should the methodology be questioned?

Question 16: Should the size and quality of the credit rating agency's staff be considered when determining NRSRO status? Should the Commission condition NRSRO recognition on a rating agency adopting minimum standards for the training and qualifications of its credit analysts? If so, what entity should be responsible for oversight of qualifications and training? How could the Commission verify whether a member of a rating agency's staff is or was previously subject to disciplinary action by a financial (or other) regulatory authority?

Answer 16: Consistent with our response to question thirteen, regulatory oversight of the training methods will add little value. Some form of debarment from working at a rating agency could be useful.

Question 17: Should the Commission condition NRSRO recognition on an entity's meeting standards for a minimum number of rating analysts or a maximum average number of issues covered per analyst? For example, should the Commission question whether a single analyst can credibly and reliably issue and keep current credit ratings on securities issued by hundreds of different issuers? Or would this level of scrutiny involve the Commission too deeply in the business practices of rating agencies?

Answer 17: The system should be self-policing. If the analytical quality is to remain high, the analysts will have to maintain reasonable workloads.

Question 18: Is a credit rating agency's organizational structure an appropriate factor to consider when evaluating a request for NRSRO status? Should the agency that seeks recognition consent to limiting its business to issuing credit ratings or could it conduct other activities, such as rating advisory services?

Answer 18: The issue is to eliminate conflicts, not to isolate or segregate them.

Question 19: Should the Commission consider a credit rating agency's financial resources as a factor in determining NRSRO status? If so, how? Should NRSRO recognition be conditioned on a rating agency meeting minimum capital or revenue requirements?

Answer 19: This seems to be an unnecessary barrier to entry. There are no such criteria applied as to whether an issuer can sell securities.

Question 20: Should a rating agency that confines its activity to a limited sector of the debt market be considered for NRSRO recognition? Should a rating agency that confines its activity to a limited (or largely non-U.S.) geographic area also be considered?

Answer 20: If the analyses by the agency is good, yes to both questions.

Question 21: Should the Commission consider a provisional NRSRO status for rating agencies that comply with NRSRO recognition criteria but lack national recognition?

Answer 21: Provisional status seems illogical since we do not believe that national recognition is the key.

Question 22: Should the Commission develop supplemental criteria to evaluate ratings quality that would be applicable to both rating agencies performing traditional fundamental credit analysis and those primarily reliant on statistical models?

Answer 22: Good luck.

Question 23: Should the Commission consider other criteria in making the NRSRO determination, such as the existence of effective procedures reasonably designed to prevent conflicts of interest and alleged anticompetitive, abusive, and unfair practices, and improve information flow surrounding the ratings process?

Answer 23: All of the above should be a pre-requisite for NRSRO consideration.

Question 24: Should the Commission expect NRSROs to follow generally accepted industry standards of diligence? If so, should the Commission encourage the establishment of a committee of market participants to develop those standards? Or should they be devised through other means?

Answer 24: The NRSROs create the market standards. To succeed they will have to be diligent.

Question 25: Should recognition of NRSROs occur through Commission action (rather than through staff no-action letters)? Should the Commission establish an appeal process if the staff remains responsible for the recognition of NRSROs?

Answer 25: Since there should be a relatively small number of actions, Commission action seems appropriate. No-action letters are too passive a vehicle.

Question 26: Should the Commission publicize applications for NRSRO recognition, and seek public comment on the credibility and reliability of the applicant's ratings?

Answer 26: Definitely yes.

Question 27: Should the Commission establish a time period to serve as a goal for action on applications for NRSRO recognition? If so, would an appropriate time period be 90 days after all required information has been received, or a shorter or longer period?

Answer 27: Ninety days seems reasonable.

Question 28: Should NRSRO recognition be conditioned on an NRSRO's meeting the original qualification criteria on a continuing basis? If so, should a failure to meet the original qualification criteria lead to revocation of NRSRO recognition? Should some other standard of revocation apply?

Answer 28: The NRSRO should meet the criteria on a continuing basis with a reasonable timeframe to address and correct alleged failures.

Question 29: What would be the appropriate frequency and intensity of any ongoing Commission review of an NRSRO's continuing compliance with the original qualification criteria?

Answer 29: Every two years. An annual basis might provide too narrow a perspective.

Question 30: Should NRSRO recognition be conditioned on a rating agency's filing annual certifications with the Commission that it continues to comply with all of the NRSRO criteria?

Answer 30: The annual certification is reasonable. The key issue is what will be the criteria.

Question 31: Should the Commission solicit public comment on the performance of each NRSRO, including whether the NRSRO's ratings continue to be viewed as credible and reliable? If so, how frequently should public comment be solicited (e.g., annually)?

Answer 31: Public comment on the performance of the NRSROs should be a factor in determining whether an NRSRO should keep that designation.

Question 32: Should NRSROs be subject to greater regulatory oversight? If so, what form should this additional oversight take? If necessary, should the Commission seek additional jurisdictional authority from Congress?

Answer 32: No to all questions.

Question 33: Should NRSRO recognition be conditioned on a rating agency's registering as an investment adviser under the Advisers Act? If so, how should the various sections of the Advisers Act apply to NRSROs? Could the Advisers Act rules be amended to make them more relevant to the businesses of NRSROs? Alternatively, would it be more appropriate for the Commission to adopt a separate registration and regulatory regime for NRSROs?

Answer 33: No comment. We are not experts on the Advisers Act.

Question 34: Should NRSRO recognition be conditioned on recordkeeping requirements specifically tailored to the ratings business? Should NRSRO recognition be conditioned on a rating agency's maintaining records relating to the ratings business, including those relating to rating decisions?

Answer 34: If the rating decisions are published, this in itself is the primary record-keeping.

Question 35: Are there minimum standards or best practices to which NRSROs should adhere? If so, how should these be established? By the Commission? By the industry, with Commission oversight? Should they be incorporated into the conditions for NRSRO recognition? Would it, or would it not, be a productive use of Commission resources to develop the expertise to review, e.g., issues related to the quality and diligence of the ratings analysis?

Answer 35: It is difficult to conceive how the Commission could add to the quality and diligence of the rating analysis as it is currently done at the larger rating agencies.

Question 36: If a currently recognized NRSRO gave up its NRSRO recognition because of concerns regarding the regulatory and liability environment, what effect, if any, would that action have on the market?

Answer 36: Negative if the NRSRO was otherwise doing a good job at the analysis.

Question 37: Should the Commission condition NRSRO recognition on an NRSRO's agreeing to document its procedures that address potential conflicts of interest in its business including, but not limited to, potential issuer and subscriber influence? If so, what other potential conflicts should these procedures address?

Answer 37: The issue is to eliminate the conflicts, not to find a way to disclose them.

Question 38: To what extent could concerns regarding potential conflicts of interest be addressed through the disclosure of existing and potential conflicts of interest when an NRSRO publishes ratings?

Answer 38: The issue is to eliminate the conflicts, not to find a way to disclose them.

Question 39: Should NRSRO recognition be conditioned on an NRSRO prohibiting employees involved in the ratings process (e.g., rating analysts and rating committee members) from participating in the solicitation of new business and from fee negotiations? Would conditioning NRSRO recognition on a rating agency's establishing strict firewalls between employees in these areas and credit analysts address potential conflicts? Should the Commission also address the credit analyst compensation structure to minimize potential conflicts of interest?

Answer 39: The prohibition on new business activities and fee negotiations only works for the largest firms. To impose such sanctions on all NRSRO candidates would be an unfair barrier to competition.

Question 40: Should NRSRO recognition be conditioned on an agreement by a rating agency not to offer consulting or other advisory services to entities it rates? Could concerns regarding conflicts of interest be addressed by limiting or restricting consulting or advisory services offered by rating agencies?

Answer 40: It will be difficult to define permitted and non-permitted advisory activities. In our opinion, no advisory activities should be permitted.

Question 41: Should NRSRO recognition be conditioned on a prohibition on credit rating analysts employed by NRSROs from discussing rating actions with subscribers? If not prohibited, should the Commission adopt limits on contacts between analysts and subscribers? Or are existing remedies - antifraud, contractual, or otherwise - sufficient to deter inappropriate disclosures to subscribers?

Answer 41: Existing remedies should be sufficient. Part of the reason to pay for a subscription is to have access to the analysts. As long as the analyst does not disclose confidential information, there should be no problem.

Question 42: Should NRSRO recognition be conditioned on a rating agency having adequate financial resources (e.g., net assets of at least $100,000, or annual gross revenues of at least $1,000,000) to reduce dependence on individual issuers or subscribers?

Answer 42: If a market acceptance standard is employed, this should not be necessary.

Question 43: Should NRSRO recognition be conditioned on a rating agency not deriving more than a certain percentage of its revenues (e.g., 3%) from a single source to help assure that the NRSRO operates independently of economic pressures from individual customers?

If a market acceptance standard is employed, this should not be necessary.

Question 44: Are there other ways to address potential conflicts of interest in the credit rating business or to minimize their consequences?

Answer 44: Define and then prohibit such practices.

Question 45: Should the Commission identify specific anti-competitive practices that NRSROs would agree to prohibit as a condition to NRSRO recognition? If so, what are those practices?

Answer 45: Yes.

Question 46: Would it be sufficient to condition NRSRO recognition on the adoption of procedures intended to prevent anti-competitive, abusive, and unfair practices from occurring?

Answer 46: In our opinion, yes.

Question 47: Should NRSRO recognition specifically be conditioned on an NRSRO's agreeing to forbear from requiring issuers to purchase ancillary services as a precondition for performance of the ratings service?

Answer 47: Yes.

Question 48: Should NRSRO recognition specifically be conditioned on an NRSRO's not engaging in specified practices with respect to unsolicited ratings (e.g., sending a bill for an unsolicited rating, sending a fee schedule and "encouraging" payment, indicating a rating might be improved with the cooperation of the issuer)?

Answer 48: Yes.

Question 49: Should the Commission address concerns about information flow from rating agencies? If so, should the Commission condition NRSRO recognition on a rating agency's agreeing to establish procedures to assure certain disclosures relating to its ratings business, such as those described above? Are there other disclosures that could be appropriate?

Answer 49: If the NRSRO standard is linked to market acceptance, the information flow should not be a problem.

Question 50: Specifically, should NRSRO recognition be conditioned on a rating agency disclosing the key bases of, and assumptions underlying its rating decisions? If so, should these disclosures be made pursuant to standards developed by the industry, or otherwise?

Answer 50: This question implies regulation of the content of a rating decision or announcement and should be avoided. The market will make its own demands of the NRSROs as to what should be contained in their decisions.

Question 51: Would it be advisable for the Commission to condition NRSRO recognition on a rating agency's agreeing to disclose performance information periodically? If so, what type of performance information would be most useful? How often should it be disclosed?

Answer 51: Some of the current NRSROs disclose "performance", but it is difficult to measure. A simple graphical timeline showing the rating an issuer should suffice.

Question 52: Should NRSRO recognition be conditioned on a rating agency's disclosing whether or not an issuer participated in the rating process? Or, could issuers be required to make such disclosures?

Answer 52: This is best left unsaid. Participation can have many levels. It can have quantitative dimensions such as whether business segment results and/or projections were supplied. Subjective criteria would include whether management was forthcoming in its responses or whether selected questions went unanswered. Another dimension could also be the rank or seniority of the participants.

Question 53: Concerns have been raised that certain credit rating agencies make their credit ratings available only to paid subscribers, and that it would be inappropriate to require users of credit ratings to subscribe for a fee to an NRSRO's services to obtain credit ratings for regulatory purposes. What steps, if any, should the Commission take to address these concerns? For example, should NRSRO recognition be conditioned on a rating agency's agreeing to public dissemination of its ratings on a widespread basis at no cost, as is currently the case?

Answer 53: The major rating agencies generally make their ratings publicly available through their web-sites and through press releases. The fees paid by investors relate to how much of the analyses is made available and the speed with which information is received as subscribers can elect to receive different levels of notification (or alerts) when ratings change. Fee paying subscribers do not have to initiate the process by watching for press releases.

Question 54: Should NRSRO recognition be conditioned on a rating agency's implementing procedures to assure public notification when it ceases rating/following an issuer. If so, what form of public notification would be appropriate?

Answer 54: Some procedure should be established. The best method would seem to be the same method as was used to disseminate the rating information in the first place.

Question 55: What steps, if any, can the Commission take to improve the extent and quality of disclosure by issuers to rating agencies or to the public generally, and in particular, regarding: (a) ratings triggers in financial covenants tied to downgrades; (b) conditional elements of material financial contracts; (c) short-term credit facilities; (d) special purpose entities; and (e) material future liabilities.

Answer 55: If the items are material, they should be being disclosed under existing rules. The items cited in this question (with the possible exception of (b)) all appear material.

Question 56: Is it appropriate for the Commission to take steps to minimize the ratings "cliff" that has been represented to be particularly pronounced in the commercial paper market? If so, what steps should the Commission take?