Financial Executives International
July 25, 2003
Mr. Jonathan G. Katz
Re: Commission Request for Comment on Rating Agencies and the Use of Credit Ratings Under the Federal Securities Laws (File No: S7-12-03)
Dear Mr. Katz:
Financial Executives International's1 (FEI) Committee on Corporate Finance (CCF) appreciates the opportunity to comment on the Securities and Exchange Commission's concept release regarding rating agencies and the use of credit ratings under federal securities laws.2 The Commission states that as part of the Commission's review of the role of credit rating agencies in the operation of the securities markets, the Commission is seeking 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.3
The issues raised by the Commission in the Concept Release are important ones, both for the proper functioning of the debt markets and the potential impact any changes might have on capital formation. In the interest of efficiency, we will focus our comments on the major questions raised in the Release.
The Commission asks whether it should eliminate the nationally recognized statistical rating organization (NRSRO) designation from Commission rules. CCF strongly believes the Commission should retain the NRSRO designation for at least two reasons: (1) In an age of unregulated mass communication, there are numerous inaccurate, poorly-analyzed sources of information on credit. This makes it substantially more difficult for investors to determine which ratings are reliable and which are not; (2) By retaining the NRSRO designation, the Commission ensures that ratings for different issuers can be easily compared and that the methodology applied across different companies is relatively consistent. However, we do believe the number of entities that receive NRSRO status can be increased somewhat so as to achieve a better balance between the need for consistency and easily recognized ratings on the one hand and competition and transparency on the other.
The Commission asks 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. While some efficiency may be gained by using broker-dealers to develop credit ratings, the risk of impropriety and other problems both real and/or perceived seem to far outweigh any efficiency gains. In today's post-Enron environment, firewalls are not perceived as an adequate internal control particularly when considering independence. The SEC should avoid any action that could cause investor concern particularly around the independence, consistency or credibility of a credit rating. Even with a system that includes documentation of procedures, there could be investor concern around the quality of work and consistency of practices employed by the broker-dealers.
On another matter, the idea of larger broker-dealers selling their internally generated ratings to smaller broker-dealers is inconceivable. While this would appear to create a more competitive environment, it certainly seems that selling rating services and providing internally generated ratings is not feasible or compatible. The SEC should not take any action that jeopardizes the independence, consistency or credibility of credit ratings no matter what the gain.
The Commission asks whether the criteria currently used to determine whether a credit rating agency qualifies as an NRSRO are appropriate. Commission staff currently considers two factors in determining whether a credit rating agency qualifies as an NRSRO. The most important factor is that the rating agency is nationally recognized as an issuer of credible and reliable ratings by the predominant users of securities ratings. The second factor is an assessment by the staff of the operational capability and reliability of each rating organization. This assessment covers six areas: 1) the organizational structure of the rating organization; 2) the rating organization's financial resources; 3) the size, experience and training of the rating organization's staff; 4) the rating organization's independence from the companies it rates; 5) the rating organization's rating procedures; and 6) whether the rating organization has internal procedures to prevent the misuse of non-public information and whether those procedures are followed.4
In general we believe that the two factors above, as well as the key components within the operational assessment, are adequate. However, we believe that the staff should put a greater weight on the operational assessment of each rating agency and do so on a regular basis and not just during the initial NRSRO selection. The NRSRO process is self-fulfilling in the sense that those agencies that are awarded NRSRO status will inevitably become the entities that are most widely recognized in the marketplace. The NRSRO status of each rating agency should be reviewed on a periodic basis (every 3-5 years) to ensure that it continues to meet the operational assessment criteria. The outcome of the reviews could potentially result in fines and/or removal of NRSRO status if significant weaknesses are identified.
The Commission notes that some commentators believe the NRSRO designation acts as a barrier to entry into the credit rating business.5 CCF does not believe this to be the case. The only barrier presented to rating agencies seeking the NRSRO designation is their qualifications. The Commission should demand that any rating agency seeking the NRSRO designation satisfy the rigorous assessment criteria.
On a related note, the Commission asks whether a rating agency that confines its activity to a limited sector of the debt market should be considered for NRSRO recognition. CCF strongly discourages the Commission from awarding NRSRO status to such rating agencies. By confining its activity to a limited sector of the debt market, a rating agency would lose the relative perspective of the whole market. Also, since investors move money from sector to sector there should be comparable ratings across all sectors. This would not happen if the rating agencies took a balkanized approach to the debt market.
The Commission then asks whether NRSROs should be subject to greater regulatory oversight. As indicated above, CCF believes it would be beneficial for a regulatory agency to conduct performance audits of the rating agencies on a periodic basis. There should not be any regulation whatsoever with respect to the methodology each agency utilizes to determine a rating. However, there should be some ongoing assessment of an agency's performance and some form of penalty in the event they are deemed negligent in certain situations.
In response to the Commission's question regarding the need for NRSROs to document their procedures for addressing potential conflicts of interest, CCF believes this would be helpful for reference purposes, but unlikely to have a significant impact on rating agency behavior. In general, CCF believes that conflict of interest arising from the revenues that the agencies receive from issuers has been effectively managed and does not require a fundamental change in the rating agencies' business models. On the other hand, CCF believes that rating agencies should focus on their core activity of assigning credit ratings and should not be allowed to offer consulting or other advisory services to the entities they rate. Even though the rating agencies may have mechanisms in place to ensure that there is a firewall between their ratings and advisory groups, it is impossible to eliminate the leverage that rating agencies have with issuers. Although rating valuation services are important tools for issuers, it is preferable for such analysis to be provided by financial institutions or other advisory firms.
The Commission asks whether it should identify specific anti-competitive practices that the NRSROs would agree to prohibit as a condition to NRSRO recognition. While there is nothing wrong with having NRSROs certify that they will not engage in specific anti-competitive practices, there must be a subsequent evaluation as to whether they indeed are abiding by that commitment.
The Commission asks whether it should address concerns about information flow from the rating agencies, and whether it should require NRSROs to establish procedures to assure certain disclosures relating to its ratings business. CCF believes the rating agencies have done a relatively good job of explaining their respective rating methodologies and the key factors they take into account in determining a rating. Generally the factors that drive changes in ratings are sufficiently clear to investors. CCF therefore does not believe it is necessary for the agencies to disclose absolutely all information that is available to them, especially information that is obtained on a confidential basis from issuer management. The rating agencies should not be required to play the role of the disclosure agency for issuers.
In summary, CCF encourages the Commission to adopt a two-fold process for rating agency oversight: (1) When a rating agency seeks recognition as an NRSRO, the Commission should conduct a thorough assessment to determine whether the agency is qualified for such recognition. As part of this process, the Commission should require the agency to document its procedures for addressing potential conflicts of interest. The applicant agency should also be required to certify that it will not engage in specified anti-competitive practices. (2) Every three to five years, the NRSRO should be subject to an intensive audit to determine whether it remains qualified for such recognition, and to ensure that it is abiding by its certifications and documented procedures. The Commission should have the authority to penalize an NRSRO for "failing" an audit, and those penalties should range from fines to "disbarment".
CCF appreciates the opportunity to comment on the Concept Release. Should you have any questions regarding our comments, please contact Mark Prysock at 202-626-7804.
1 Financial Executives International is a professional association representing the interests of more than 15,000 CFOs, treasurers, controllers, tax directors, and other senior financial executives from over 8,000 major companies throughout the United States and Canada. FEI represents both providers and users of financial information.
2 Securities Exchange Act Release No. 47972 (June 4, 2003), 68 FR 35258 (June 12, 2003) ("Concept Release")
3 Ibid at 35258
4 Ibid at 35260
5 Ibid at 35259