SUBMISSION TO THE SECURITIES EXCHANGE COMMISSION
450 Fifth Street, NW, Washington, DC 20549

by

DR. PATRICK JAMES CARAGATA,
MANAGING DIRECTOR AND CEO
RAPID RATINGS PTY LIMITED
(a new generation corporate credit rating agency)

488 Queen Street, GPO Box 2584, BRISBANE AUSTRALIA
info@rapidratings.com; www.rapidratings.com

regarding

AGENCIES AND THE USE OF CREDIT RATINGS
UNDER THE FEDERAL SECURITIES LAWS: FILE NO. S7-12-03

Submitted electronically to
rule-comments@sec.gov.

November 3, 2003

SUBMISSION TO THE SECURITIES EXCHANGE COMMISSION

Introduction

Rapid Ratings' welcomes this opportunity to make a contribution to the discussion of NRSRO¹ regulations. Rapid Ratings Pty Ltd is an independent, software-based and webservice-based global corporate credit rating agency headquartered in Australia with offices in Australia, New Zealand, Singapore, Europe and North America. More details about the company and its history are available on www.rapidratings.com. Our only inputs for ratings are audited financials (income statement, balance sheet and cash flows).

We take a scientific approach to the financials based on our industry-specific multivariate econometric panel data model set embedded in our software. Despite this seemingly narrow approach, Rapid Ratings track record for anticipating the collapse of major companies is second to none over the last 5 years because of the quality of the software.

Corporate financial statements are a mirror on the capabilities of management and the company to deal with internal and external risks and opportunities. And typically, financial manipulation is preceded by financial deterioration (Enron, WorldCom, Adelphia Communications, HIH Insurance etc), which can be tracked by our software.

Rapid Ratings' generic business model is to provide ratings of second parties (listed and unlisted companies) to third parties (institutional investors, banks, insurance companies, large creditors, accounting firms etc). This business model is different from the traditional rating agencies, which rate second parties (listed companies) and are paid by those companies. The next generation of US regulations affecting corporate credit rating agencies needs to reflect the emergence of a new generation of corporate credit rating agencies and their differences from the traditional rating agencies.

The Next Generation of Regulations Affecting NRSROs

The ideal regulatory regime has foresight and anticipates its consequences amidst changing circumstances over the next several decades so that there is much less need for constant adjustments to the regulations. Looking back to the creation of the 1975 NRSRO regime, one is struck by its significant long-term implications in several areas:

• The number of pieces of legislation which now incorporate NRSRO references and requirements.²

• The number of market players (banks, insurance companies, mutual funds, pension funds etc) that are required to incorporate NRSRO ratings in their business decisions.

• The rate of return of the NRSROs. ³

• The appetite for takeovers of those companies which have the privileged NRSRO status and the related lessening of competition, and the related concentration of market share among the Big 3 rating agencies.

• The market power of the remaining NRSROs, not just in the US but globally.

As the SEC noted in Agencies And The Use Of Credit Ratings Under The Federal Securities Laws: file no. S7-12-03, the original intent of the regulations in 1975 was rather narrow: "The Commission's initial regulatory use of the term "NRSRO" was solely to provide a method for determining capital charges on different grades of debt securities under the Commission's net capital rule for broker-dealers, Rule 15c3-1 under the Exchange Act (the "Net Capital Rule"). Over time, as the reliance on credit rating agency ratings increased, so too did the use of the NRSRO concept." Obviously, then, it is likely that any new changes to the NRSRO regulations will have widespread and long-term ramifications.

A. Alternatives to the NRSRO Designation

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

Rapid Ratings' Response: No, NRSRO designation should not be eliminated, but some fundamental changes are needed.

I The Need for a Tripartite Approach to NRSRO Status

Current NRSRO Criteria

"The single most important criterion is that the rating agency is widely accepted in the U.S. as an issuer of credible and reliable ratings by the predominant users of securities ratings. The staff also reviews the operational capability and reliability of the rating agency, including: (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 reliable ratings); and (6) whether the rating agency has internal procedures to prevent the misuse of non-public information and to minimize possible conflicts of interest, and whether those procedures are followed. These criteria are intended to reflect the view of the marketplace as to the credibility of the credit rating agency, and were developed, in part, after evaluating public comments received by the Commission on the NRSRO designation."⁴

Rapid Ratings' principal concern, raised earlier by the US Justice Department,⁵ is that the NRSRO criteria act as a barrier to entry, in a catch-22 manner. A new rating agency cannot get national recognition without NRSRO status, and it cannot get NRSRO status without national recognition. A related concern is the need to avoid adding new barriers to entry in the future as the existing regulations are adjusted.

While the barriers to entry problem is a serious criticism, Rapid Ratings does not believe that NRSRO criteria should be eliminated because minimum standards, systematic risk rating benchmarks within and across industries, and ongoing monitoring are required to police the market policemen (the rating agencies). NRSRO status helps to achieve these goals. It is the market that must produce the ratings processes (as a form of self-regulation), but it is the government that must, at arms-length, provide guidance and supervision of that process.

The public (largely but not exclusively, investors and lenders) wants objectivity, independence and integrity from the ratings process. Only thoughtful government regulation will achieve that. The alternatives of letting the market decide alone or letting the government issue ratings are, respectively, beset by a high potential for ethical misconduct, inconsistent signals, and the problem of the scarcity of technical competence.

Allowing broker-dealers' or banks' internally-developed credit ratings to determine the capital charges on different grades of debt securities does not offer the market a systematic and comprehensive approach to corporate credit ratings. At minimum, external, privately owned and/or publicly listed corporate rating agencies provide similar and sometimes differentiated⁶ signals to all investors and lenders; albeit, currently, there are deficiencies in those signals which can be corrected. Strict firewalls are valuable but do not overcome the problem of the need for common standards and accurate signals in the market.

Requiring each broker/bank to obtain regulatory approval of its credit rating procedures and rating categories before it could use internal credit ratings for calculating capital charges fails to offer the market a common benchmark.

In general, options arising from Rule 15c3-1 under the Exchange Act are complements to the current NRSRO process and not substitutes for this process. Clearly, the rating processes of broker/dealers ands banks need to be more rigorous, but they are not stand-alone options.

The option of dropping the objective test under the Investment Company Act of 1940 adds too much risk to the market by eliminating standardised, professional second opinions. The message here is that the external NRSRO rating agencies need to do a better job, rather than no job at all. The NRSRO rating agencies also need more competition.

Our recommended approach would be to change the weight placed on the existing input-based criteria by reducing emphasis on them and by adding two new sets of factors: output criteria and tightened competition regulations. This is what we call a Tripartite Approach to NRSRO status, which we shall discuss below.

II Rationale for a Tripartite Approach to NRSRO Status

There are several reasons for this approach:

1. The barriers to entry problem. Oligopolies have a natural tendency to shelter behind regulatory protection⁷ and, through lobbying, will seek to defend the status quo regardless of changes in market conditions, ratings processes and technologies. Hence, there needs to be some new rules.

2. Opportunity Cost: While on average, the Big 3 rating agencies have a good track record in default prediction,⁸ the track record of the Big 3 rating agencies in anticipating large corporate failures in the last ten years has been quite poor.⁹ The following companies¹⁰ (this is a partial list) went into receivership or liquidation with an investment grade rating from one or more of the Big 3 rating agencies: Confederation Life (1994), Enron (2001), Executive Life, First Capital, Hafnia (1993), HIH Insurance Co (2001), Monarch, Mutual Benefit Life, Orange County (1994), Southern Cal. Edison (2001), and WorldCom (2002). This means that there has been a huge economic deadweight loss or waste that arose because the information conveyed to the market by the rating agencies prior to the demise of the companies did not act as an early warning for loss and thus help avert the loss. In each case, the opportunity cost was high, in terms of lost assets, jobs etc. Hence, there is a need for new ideas and techniques and more competition in the ratings market. In the aftermath of the ratings failures for Enron and WorldCom, more than marginal adjustments to the regulatory regime are called for. The failure to predict these corporate collapse does not, however, mean that the rating agencies are responsible for the collapses (vide, County of Orange v. The McGraw-Hill Companies, d/b/a Standard & Poor''s Ratings Services, 1996).¹¹

3. Market Opinions About the Big Three Rating Agencies: Accuracy, Timeliness and Usefulness:

   There is a big difference between the credibility arising from the regulatory requirement for banks, insurance companies, stockbrokers, mutual funds and pension funds etc to use ratings, and the actual efficiency and effectiveness of those ratings in the market as the following citations illustrate:

   1. "investors are also critical of the lack of early warning signals from the credit rating agencies." Euromoney, Investors Turn Cool on the Rating Game, January 2002

   2. In a... "September survey by the Association for Financial Professionals, the poll found that 29% of financial executives who work for companies with rated debt believe their ratings are inaccurate, while 40% think it takes too long for changes in the company's finances to show up in the rating." Business Week Online, December 9, 2002 Opening Up the Credit Rating Club?

   3. "... there is no question that the system for rating debt--corporate, municipal, mortgage and asset-backed and federal agency issues--could be vastly improved. According to a recent study by the Association for Financial Professionals (AFP), corporate credit analysis would do better by industry competition and a more vigilant U.S. Securities and Exchange Commission. The survey, released today at the AFP's annual meeting, polled 327 corporate finance executives and 181 financial industry service providers on their opinions of the state of credit rating." More Competition, better Ratings, Forbes, November 4, 2002.

   4. "...a US university study released in June 2001 found that 71 percent of institutional investors ( out of a sample size of 114) thought credit ratings on corporate bonds lagged behind an issuer's creditworthiness at any given moment. (Interestingly, though, they also polled 100 CFOs, of whom 74 percent believed that ratings were up-to-date)." July 2002 CFOAsia ¹²

   5. "Relying on the rating agencies to specify what is a good investment... makes it easier to pass the buck in the case of a default..." Euromoney, January 2002

   6. "the agencies do a reasonable job of assessing relative credit risks [the lower the rating the higher the risk of default], but agency ratings have been a less reliable guide to absolute credit risks [because] default probabilities associated with specific letter ratings have drifted over time" Cantor and Packer, 1994, Federal Reserve Bank of New York.

   7. "Rating agencies have to be very careful with their power. If they are too pre-emptive they might in fact precipitate the problems they are warning about." Chin Gan, CEO, Duff & Phelps Asia, Euromoney, January 1998

   8. "Credit ratings do not provide useful or timely information about the credit-worthiness of companies in today's markets. Academic studies tend to show that information in credit ratings is of marginal value at best because ... (it has) already been incorporated into the share price. One well-known study showed that the ratings provided by rating agencies lagged the information contained in securities prices by a full year." Prof. Jonathan R. Macey, Cornell Law School;¹³

   9. "Most of the analysts don't think much of rating agencies. The truth of the matter is they use rating agencies as an insurance device," one seasoned market watcher said. "If things go sour, the pension fund can say `we checked with the rating agency and they gave it a clean bill of health', in other words it is not our fault." 1 February 2002 BBC News

   10. "Analysts can no longer assign a rating to a company then file it away until the same time next year, secure in the knowledge that not much is going to change. Credit quality is shifting from day to day, sometimes hour to hour as Enron's did. At the same time, it is doubtful that the agencies have the resources to cope with the new environment." Euromoney, January 2002

   11. The agencies think about market implications and reactions more than they should. They should call a spade and a spade." Tony Rodriguez, global head of corporate bonds. Credit Suisse Asset Management, Euromoney, January 2002

   12. "The number of suboptimal investment decisions we have to make because of rating agency actions is phenomenal." a European fund manager" Euromoney, January 2002

   13. "The agencies keep telling us that the rating trends are negative, but that's only because they didn't get the ratings right in the first place." Buy-Side Credit Analyst, Euromoney, April 2001

   14. "There is a risk, particularly since there are so few rating agencies (for most markets, only two), that once ratings are enshrined by regulators, the markets may become less vigilant about the agencies' work." The Economist April 6, 1996

   15. "I think what is needed in the future is more competition not less competition to keep the rating agencies on their toes." SVP and Chief Economist, Wells Fargo & Co. 3 March 2000, American Banker

   Hence, there is a need for new ideas, new techniques and new competition in the ratings market.

4. The traditional NRSRO criteria were designed for rating agencies with a traditional business model: Business Model Type 1: the rating agency is paid by second parties (issuers of debt) to rate those parties. But new generation rating agencies, such as Rapid Ratings, have an entirely different business model. Business Model Type 2: New generation rating agencies are paid by third parties (banks, insurance companies, investment funds, pension funds, large creditors etc) to rate second parties (listed and/or unlisted companies). Thus, in the Type 2 Model, there may be no contact between the rating agency and the companies it rates and no potential for conflict of interest. In such a case, it would be unfair to require a Type 2 company to conform to criteria that pertain only to Type 1 companies.

5. Type 2 companies such as Rapid Ratings, which use an automated system for generating ratings, cannot be accused of providing an opportunity for "ratings shopping" precisely because its reports are automatically determined based on the input of audited corporate financials.

6. The Nature of the New Competitors: Once barriers to entry are made less onerous and more balanced, new entrants will bring new ideas and a refreshing level of competition to the industry. Eventually, if they have the right technology, Type 2 Rating Agencies will become larger than the Type 1 agencies because of their ability to process tens of thousands of companies at low cost. Just like Henry Ford promoted the development of "a car for every family", the Type 2 rating agencies will be able to deliver "a rating for every company". Currently, Big 3 rating agencies only rate between 10% and 25% of listed companies and less than 0.1 percent of registered companies in each country because of the cost and expertise constraints they face. Rapid Ratings can rate all companies for which it obtains audited financials, and its current low-end capacity level is 40,000 companies per day.

7. Oligopolies typically are not innovators in the market. "It does seem to be the case, however, that innovations -- such as expanding the ratings to non-traditional instruments, and adding finer gradations to ratings -- have often (though not always) been initiated by the smaller rating firms, with the larger two then following. This finding, plus the lower fees that the smaller firms charge, indicates that competition brings the same beneficial effects to this industry that it does in others."¹⁴ Hence, it is necessary to ensure that the entrenched NRSRO rating agencies do not engage in predatory behaviour and do not bury the new ideas that enter the market with small competitors.

III A Need for Output Criteria

The existing criteria are largely focused on the inputs that rating agencies use to drive their rating service. We note that Professor Lawrence White of the Stern School of Business at New York University would like to see the SEC add some output criteria in the decision-making process¹⁵. In our view, the output criteria should be based on

(a) the track record of the rating agency in predicting individual corporate declines and collapse;

(b) the track record of the rating agency in anticipating corporate turnarounds; and

(c) the ability of the rating to anticipate corporate demise ahead of the share price. If a rating agency cannot beat the share price in anticipating corporate collapse, it is questionable if that agency is adding any new information to the market. Typically, the traditional Type 1 rating agency ratings lag the share price by 1-3 years in anticipating the demise of companies.

IV The Need for Some Competition Rules

The only way to add new sustainable competition to the rating market is to prevent the Big 3 existing NRSROs from taking over new competitors (including DBRS) entering the market for the next 10 years. This prohibition should be renewable for another ten years. While Fitch needed mergers and takeovers (IBCA, Duff Phelps, Thomson) to achieve the scale required to compete with S&P and Moody's, further mergers and takeovers among or by the Big 3 would be significantly unhealthy for the ratings industry and should be prevented.

New entrants (outside S&P, Moody's, Fitch and DBRS) to NRSRO status should be allowed to grow organically based on market demand and by merger and acquisition. New methods, techniques, technology and money will flow into the industry, with general benefits for all users of ratings. The only principal concern is whether or not those new entrants can withstand the financial lure of the Big 3 or survive any predatory practices they might engage in. A principal area of concern is the services the NRSRO rating agencies will provide to the banks in preparation for Basel II deadlines in 2006, and thereafter.

The SEC should make preparations to monitor the pricing policies of the NRSROs for screening the banks commercial lending portfolio. They should also be prepared to call the NRSROs to account where there is evidence that the NRSROs are using their Type 1 rating relationship as leverage to secure contracts to screen the commercial lending portfolios of banks.

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?

We do not support eliminating NRSRO criteria. Rather, we want to see a mix of input criteria, output criteria and competition rules put in place. The input criteria should also be tailored to whether a rating agency is applying to be a Type 1 NRSRO or a Type 2 NRSRO (Business Model Type 1: the rating agency is paid by second parties (issuers of debt) to rate those parties. But new generation rating agencies, such as Rapid Ratings, have an entirely different business model. Business Model Type 2: They are paid by third parties (banks, insurance companies, investment funds, pension funds, large creditors etc) to rate second parties (listed and/or unlisted companies).

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?

All companies which handle the money of retail and wholesale clients in the debt and equity markets should be required to have an internal rating system backed by accepted standards of corporate governance (transparency, accountability and performance measurement).

Is it appropriate to require strict firewalls between the broker-dealer employees who develop internal credit ratings and those responsible for revenue production?

Yes, in order to minimise the potential for ethical misconduct.

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?

No, assuming that NRSRO criteria are maintained. Industry associations should develop a consensus on the internal criteria, in consultation with regulatory authorities. But, keep in mind diversity is important for competition. That is how we can avoid the `lemming effect'.

If so, what factors should the Commission review in determining whether to grant such approval?

Option not supported by Rapid Ratings.

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?

Option not supported by Rapid Ratings.

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?

Option not supported by Rapid Ratings.

If so, would this help to provide a more competitive marketplace for credit ratings?

Option not supported by Rapid Ratings.

To what extent should the Commission exercise additional regulatory oversight of this activity (e.g., to control potential conflicts of interest)?

Option not supported by Rapid Ratings.

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?

Option not supported by Rapid Ratings.

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?

Option not supported by Rapid Ratings.

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?

Option not supported by Rapid Ratings.

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?

Option not supported by Rapid Ratings.

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

Option not supported by Rapid Ratings.

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?

Option not supported by Rapid Ratings.

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?

Option not supported by Rapid Ratings.

B. Recognition Criteria

Existing Substantive Criteria

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?

See our response to Question 1.

Question 12a: 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)?

It is important to take into consideration that Type 2 rating agencies, whose ratings may be widely used, will be less known in the market by issuers of public debt and investors in public debt, and should not be penalised for that lower profile.

Question 12b: 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)?

It is important to take into consideration that Type 2 rating agencies will be less known in the market by issuers of public debt, and should not be penalised for that lower profile.

Question 12c: 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?

It is important to take into consideration that Type 2 rating agencies will be less known in the market by issuers of public debt, and should not be penalised for that lower profile.

Ratings are employed by many users aside from investors in debt securities, so restricting the "attestations" to "users of securities ratings" is unfair. Other users such as investment funds, hedge funds, mutual funds, investment houses, brokers/dealers, pension funds, superannuation funds, and private banks will use the ratings to determine if they should invest in the equity of a rated company, while large creditors and insurance companies will use the ratings to assess counterparty risk.

Options and Related Problems:

Option #1: attestations from or interviews with authorized officers of users of securities ratings representing a substantial percentage of the relevant market that the applicant's ratings are credible and actually relied on by the user;

Problems:

• Define what is meant by a substantial percentage.

• This is probably a large hurdle for a small company just in terms of getting access to lists of such users and then establishing a relationship.

• This hurdle favours current NRSRO companies because thresholds would likely be based on their current level of influence.

• Ratings are employed by many users aside from investors in debt securities, so restricting the "attestations" to "users of securities ratings" is unfair. Other users such as investment funds, hedge funds, mutual funds, investment houses, brokers/dealers, pension funds, superannuation funds, and private banks will use the ratings to determine if they should invest in the equity of a rated company, while large creditors and insurance companies will use the ratings to assess counterparty risk. Eventually, Type 2 ratings facilities will be available on the web for all unlisted companies. We would recommend that the SEC set a numerical threshold such as 50, 100, or 150 etc attestations from general volume users (ie not retail clients) of the ratings. Keep in mind that it is the actual track record of the rating agency in anticipating success or demise that is most important.

Option #2: statistical data demonstrating market reliance on the applicant's ratings (e.g., market movements in response to the applicant's rating changes).

Problems:

• The range and thresholds for these options need to be debated

• This decision criterion would tend to favour existing NRSRO companies because the thresholds would likely be based on their current level of influence.

Question 13a: Should the Commission condition NRSRO recognition on a rating agency developing and implementing procedures reasonably designed to ensure credible, reliable, and current ratings?

Yes, but keep in mind that there are differences between Type 1 and Type 2 procedures. For a Type 2 company such as Rapid Ratings, the procedures are exactly the same for each rating because our global webservice is based on our proprietary software.

Question 13b: 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?

Yes.

Question 13c: What minimum standards should the Commission use to determine whether the agency's ratings are current?

A rating that is no more than 12 months old should be the threshold. Keep in mind that the Type 2 rating agencies such as Rapid Ratings, whose sole inputs are financial statement data (income statement, balance sheet and cash flows) prefer to use audited financials and related notes to accounts, but can use unaudited financials with a caveat, and hence can rate a company every 3 to 6 months.

Question 13d: Should each NRSRO use uniform rating symbols, as a means of reducing the risk of marketplace confusion?

Yes, but all agencies should not be required to use the same symbols. They should, however, be required to develop a rating equivalents chart.¹⁶

Question 13e: 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?

These requirements will differ for Type 1 and Type 2 rating agencies. Thus, minimum standards should reflect the nature of the business model.

Question 13f: How could these minimum requirements be developed? By the Commission? By the industry, with Commission oversight?

The latter.

Question 14a: 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?

No. This criterion is biased in favour of Type 1 rating agencies, and against Type 2 rating agencies.

Question 14b: 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?

Absolutely not. The strong links that the Big 3 had with Enron and WorldCom did not help their ratings one iota. An arms-length approach such as Rapid Ratings' can minimise the risk of being misled. Without any contact at all, we rated Enron as junk in 1997-2000.

Question 15a: To the extent a credit rating agency uses computerized statistical models, what factors should be used to review the models?

Its track record in predicting success, turnarounds, financial distress and failure.

Question 15b: Could a credit rating agency that solely uses a computerized statistical model and no other qualitative inputs qualify as an NRSRO?

Yes. It is the track record in anticipating the success or demise that is most important. In the case of Enron, Rapid Ratings could have saved investors in Enron debt and equity millions of dollars because its ratings of Enron were generally well below investment grade in 1997, 1998, 1999 and 2000, well-ahead of the rest of the market.

Question 16a: Should the size and quality of the credit rating agency's staff be considered when determining NRSRO status?

The issue of the size of the staff is biased in favour of Type 1 rating agencies because Type 2 rating agencies use software rather than staff to do the analysis. Hence, this criterion should be de-emphasized for Type 2 rating agencies.

With respect to the quality of the staff, that is a criterion that is important for both Type 1 and Type 2 companies.

Question 16b: 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?

The issues of the training and qualifications of staff are biased in favour of Type 1 rating agencies because Type 2 rating agencies use software rather than staff to do the analysis. Hence, this criterion should be de-emphasized for Type 2 rating agencies.

Question 16c: 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?

Require each staff member to sign a warranty, with the penalty being dismissal for not telling the truth.

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?

The SEC should stay out of this area. It should not micro-manage the efficiency performance of analysts. Moreover, as Type 1 rating agencies develop software tools, their analysts will be able to handle more ratings per week.

Question 18a: Is a credit rating agency's organizational structure an appropriate factor to consider when evaluating a request for NRSRO status?

Organisational structures are changing very rapidly, with many different options being used, so a common benchmark in this area is no longer possible. Principal changes are the development of Type 2 rating agencies, which have a thin management structure and out-source various functions.

Question 18b: 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?

We have very serious concerns about the potential for conflict of interest among the NRSROs in offering rating services for banks that are required to meet Basel II standards. While we would not recommend banning this form of advisory service, Rapid Ratings believes that the SEC needs to set some strict guidelines. On a related matter, we are not opposed to rating agencies offering governance rating services. But they should be incorporated in the overall rating offered by the NRSRO, rather than being a separate process.

Question 19a: Should the Commission consider a credit rating agency's financial resources as a factor in determining NRSRO status?

Yes

Question 19b: If so, how? Should NRSRO recognition be conditioned on a rating agency meeting minimum capital or revenue requirements?

This criterion could easily become biased against the smaller Type 2 rating agencies. Thus, a differentiated set of thresholds needs to be developed. But keep in mind that a small, new entrant to the ratings market is initially going to be below some critical mass point in terms of financial resources. It is important that this criterion not be a high hurdle and thus a barrier to entry. Again, it is the track record of the rating agency that is most important in assessing NRSRO eligibility, otherwise there will be the potential to enshrine mediocrity.

Other Factors to be Considered

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?

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?

Yes.

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?

As we have indicated above, there will be some overlap of the criteria needed for Type 1 and Type 2 rating agencies, but criteria weights should be varied depending on whether a Type 1 or Type 2 rating agency is being considered.

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?

Yes. These criteria are particularly important for Type 1 rating agencies. See our comments on these matters in response to question #1 and elsewhere.

Question 24a: 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?

Type 2 rating agencies typically do not do onsite research and hence should face a different and lower level diligence standard. Rapid Ratings uses only audited financials and related notes to accounts, and does no additional research unless it encounters symptoms of financial manipulation. Developing a Committee of Market Participants for shaping diligence standards for Type 1 NRSROs is a good idea, but the standards should be subject to external scrutiny by legal, accounting and securities associations and their members, as well as academics, and not applied with the same weight, if at all, to Type 2 rating agencies.

Question 24b: Or should they be devised through other means?

See comment to question 24a.

Recognition Process

Question 25a: Should recognition of NRSROs occur through Commission action (rather than through staff no-action letters)?

Regardless of the method, the recognition process should be transparent to the market and the verdict appealable to a Rating Agency Review Board that includes SEC and non-SEC staff (similar to independent directors). This same Committee should vet ethical conduct of the NRSROs, have the right to receive and investigate formal letters of complaint from the public about the rating agencies, have the right to review the NRSRO status of each approved rating agency, the right to levy fines against them, and the right to revoke the licence in extreme circumstances.

Question 25b: Should the Commission establish an appeal process if the staff remains responsible for the recognition of NRSROs?

Yes.

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

In Australia, where we operate under a licensing system, this would be considered a gross intrusion of the privacy of the applicant. It also favours existing NRSROs who would not have been subjected to this level of scrutiny, and who could use the opportunity to challenge new entrants. This suggestion would create a significant barrier to entry unless all NRSRO licenses were issued for 3 years, after which each rating agency would have to re-apply for the licence under full scrutiny as suggested by the question. On balance, the privacy issue and the barrier to entry issue would outweigh the transparency issue raised by the question.

Question 27a: Should the Commission establish a time period to serve as a goal for action on applications for NRSRO recognition?

Yes.

Question 27b: If so, would an appropriate time period be 90 days after all required information has been received, or a shorter or longer period?

90 days is fine.

C. Examination and Oversight of NRSROs

Question 28a: Should NRSRO recognition be conditioned on an NRSRO's meeting the original qualification criteria on a continuing basis?

Yes.

Question 28b: If so, should a failure to meet the original qualification criteria lead to revocation of NRSRO recognition? Should some other standard of revocation apply?

A formal review should be held by the Rating Agency Review Board before any decision to revoke is made. This is the time to seek public comment about the agency.

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?

Each year, an NRSRO should file a short checklist stating it is complying with the terms and conditions of its NRSRO status.

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?

Yes.

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)?

Public comment should be solicited every two years, unless there is another Enron-type problem. There is no point in holding meetings and hearings for the sake of holding meetings and hearings.

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?

At this stage, there is a need for improved transparency, accountability and performance measurement among NRSROs. An SEC-based Rating Agency Review Board with appropriate regulatory powers should be set up to prepare for a more pro-active approach to NRSRO rating agency performance.

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?

It is better to have a separate registration and regulatory regime. Most, if not all, rating agencies disclaim that they are offering financial advice. Rather they are offering an opinion about the level of risk. To lump rating agencies and financial advisors in the same bracket sends the wrong message and forces NRSROs to state that their intent is to act as an advisor when in fact that does not happen. The Orange County v. Standard and Poor's case in 1996 clarified the difference and it needs to be acted on.

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?

This applies only to Type 1 rating agencies. Such records are for internal purposes only and not for external circulation.

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?

By the industry with SEC oversight.

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?

This is unlikely to happen. Currently, the NRSRO status is a conferred oligopoly right and is thus a licence to print money. If it did happen, there are other rating agencies that can perform the same function.

D. Conflicts of Interest

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?

Yes. One of the biggest areas for potential conflict of interest for the NRSROs in the future will arise from Type 1 Rating Agencies offering of rating services to banks (which they also rate) to assist with screening the bank's commercial portfolio in preparation for meeting the Basel II requirements for capital reserves. Obviously, there are the same risks whenever the Big 3 offer consulting services to their existing or emerging client base.

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?

Disclosure for his type of business activity is a viable option. But, given the emergence of rating agency consulting services, there are other business activities, which may present conflict of interest challenges.

Question 39a: 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?

For small Type I NRSRO candidates, this could present a staffing challenge. This is not a problem for Type 2 rating agencies because they do not have rating analysts, but use software instead.

Question 39b: Would conditioning NRSRO recognition on a rating agency's establishing strict firewalls between employees in these areas and credit analysts address potential conflicts?

Yes, it could be helpful.

Question 39b: Should the Commission also address the credit analyst compensation structure to minimize potential conflicts of interest?

Yes.

Question 40a: Should NRSRO recognition be conditioned on an agreement by a rating agency not to offer consulting or other advisory services to entities it rates?

We are inclined to agree that this should apply to Type 1 NRSROs, but it is not relevant to future Type 2 NRSROs because they are not paid by the companies they rate. But, we think that it is best to explore the area of consulting services offered by rating agencies and their impacts in much more detail before a decision on this matter is reached.

Question 40b: Could concerns regarding conflicts of interest be addressed by limiting or restricting consulting or advisory services offered by rating agencies?

Yes that might be the best solution, but the issue needs to be studied in much more detail before a decision is reached.

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?

We don't have enough information to answer this question.

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?

This question is biased in that its focus is on Type 1 rating agencies that are paid by the companies they rate. Nonetheless, $100,000 in net assets and $1m in revenues are reasonable thresholds for small companies to meet.

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?

Again, this question applies only to Type 1 rating agencies. It is not relevant to Type 2 rating agencies.

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

The SEC should issue a paper on current and potential conflicts of interest and the known or anticipated consequences in the rating agency business, and ask the public for comment.

E. Alleged Anticompetitive, Abusive, and Unfair 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?

Yes. The anti-competitive practices that need to be prohibited are:

• Mergers or acquisitions with other Type1 and Type 2 rating agencies for the next ten years (with a possible extension for an additional ten years)

• Predatory pricing and "bundling" with other rating agency services where the rating agency is offering a contract to a bank or insurance company to screen its commercial client base in preparation for meeting Basel II requirements.

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

The SEC may need to be more interventionist on this matter.

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?

We would tend to support this recommendation, but we believe that more research is needed before such as decision is taken.

Question 48: Should NRSRO recognition specifically be conditioned on an NRSRO's not engaging in specified practices with respect to unsolicited ratings (e.g.,

(a) sending a bill for an unsolicited rating, (YES)

(b) sending a fee schedule and "encouraging" payment, (YES)

(c) indicating a rating might be improved with the cooperation of the issuer)? NO

F. Information Flow

Question 49a: Should the Commission address concerns about information flow from rating agencies?

Yes

Question 49b: 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 below? NRSRO recognition could be conditioned on a rating agency's implementing procedures to assure appropriate disclosure of key information about its ratings and rating processes, including: (1) widespread public dissemination of its ratings; (2) identifying an unsolicited rating as such; (3) annual disclosure of specified ratings performance information; and (4) public disclosure of the key bases of, and assumptions underlying, the ratings decision (pursuant to generally accepted industry standards to be developed by a broad-based committee of market participants).

For a Type 1 rating agency, this could be a very onerous process that forces disclosure of large volumes of information as well as proprietary information about methodology. Thus, this requirement would violate commercial privacy rights. Type 2 rating agencies which base their rating decisions on software would place strict limits on disclosure of their software methodology for fear of giving away commercial secrets.

Question 49b: Could NRSRO recognition be conditioned on a rating agency's implementing procedures to assure appropriate public notification when it ceases rating/following an issuer?

This is too trivial an issue to be made an NRSRO condition of entry.

Question 49c: Are there other disclosures that could be appropriate?

No other thoughts on this matter come to mind.

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?

See comments above

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?

More discussion is needed on this matter before a decision is made.

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?

No comment.

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?

Type 1 rating agencies earn the bulk of their income from the companies they rate. Type 2 rating agencies usually depend entirely on subscriptions for their revenue. To apply a Type 1 standard in this case to a Type 2 company is unfair and would constitute a serious barrier to entry because, in order to receive NRSRO status, a Type 2 rating agency would be required to give away some part of its revenue stream. An alternative, which we practice currently in New Zealand, is to write an article twice yearly in the country's leading business newspaper, the National Business Review, providing full ratings detail on the top 10 companies, and then less detail for the remainder of the top 50 companies by market capitalisation.

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?

See comments above.

____________________________

1	Nationally recognized statistical rating organizations
2	"Several regulations issued pursuant to the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940 have incorporated the term NRSRO as it is used in the net capital rule. For example, Rule 2a-7 under the Investment Company Act of 1940 limits money market funds to investing in only high quality short-term instruments. Under Rule 2a-7, NRSRO ratings provide minimum quality investment standards for money market funds. A money market fund is permitted to invest in securities ranked by an NRSRO in the two highest rating categories for short-term debt. Over $2 trillion of investor assets are held in money market funds meeting the standards of Rule 2a-7. In addition, offerings of certain nonconvertible debt and preferred securities that are rated investment grade by at least one NRSRO can be registered on Form S-3 without the issuer satisfying a minimum public float test. Generally, Form S-3 is a short-form registration statement designed for use by issuers that are subject to periodic reporting requirements under the Securities Exchange Act of 1934. Congress itself employed the term "NRSRO" when it defined the term "mortgage-related security" in Section 3(a) (41) of the Securities Exchange Act of 19334. The term "mortgage-related security was added by the Secondary Mortgage Market Enhancement Act of 1984, and it required that such securities be rated in one of the two highest rating categories by at least one NRSRO. Finally, other regulatory bodies, including banking regulators both at home and abroad, employ the concept of NRSRO in their regulations." Testimony Concerning the Role of Rating Agencies in the US Securities Markets, http://www.sec.gov/news/testimony/032002tsih.htm
3	"Revenues at Moody's have grown at a compound rate of 17 percent a year since the beginning of the 1980s, making it one of the most successful financial information companies around." Financial Times 16 December 1999; "The rating agencies profit margins have always been among the highest on Wall Street -- 40%, according to some analysts -- so any increase in business means a substantial increase in profits." Crain's New York Business, 16 June 1998
4	Agencies and the Use of Credit Ratings under the Federal Securities Laws, Securities and Exchange Commission, [Release Nos.33-8236; 34-47972; IC-26066; File No.S7-12-03] RIN 3235-AH28.
5	"Comments of the United States Department of Justice in the Matter of File No. S7-33-97 Proposed Amendments to Rule 15c3-1 under the Securities Exchange Act of 1934, U.S. Department of Justice, (March 6, 1998)
6	A healthy rating market is not characterised by all rating agencies rating each company at the same level. On the contrary, it is far healthier for differences of rating opinion to exist in the market, and this can only arise in an environment where government does not create excessive barriers to entry and does not permit oligopolistic market power to smother new ideas and technologies.
7	Just as do companies protected by import tariffs or non-tariff barriers.
8	"The record on ratings and actual defaults for corporations in the past shows a high correlation between credit quality and default remoteness: the higher the rating, the lower the probability of default, and vice versa. On this score, ratings, on average, are a good indicator of relative creditworthiness." Adams, C., et al, 1999, International Capital Markets: Developments, Prospects and Key Policy Issues, Washington DC: International Monetary Fund, September.
9	For example, see The Economist, July 15, 1995, p.53.
10	With apologies, we were unable to obtain the year of default of all of the companies.
11	http://www.oc.ca.gov/ceo/finance/fin_white_v_county.htm; http://library.lp.findlaw.com/articles/file/00095/005270/title/subject/topic/banking%20%20finance%20law_lending%20%20secured%20transactions/filename/bankingfinancelaw_1_19#INDEPENDENT
12	"Ratings Under Review" www.cfoasia.com/archives/200207-04.htm
13	www.blonnet.com/2002/07/17
14	Lawrence J. White, The Credit Rating Industry: An Industrial Organization Analysis, Stern School Of Business, New York University, June 1, 2001.
15	The SEC's Other Problem, Lawrence J. White, Testimony prepared for delivery before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Committee on Financial Services, U.S. House of Representatives, at the hearing entitled "Rating the Rating Agencies: the State of Transparency and Competition," Wednesday, April 2, 2003, 10:00am, Room 2128 of the Rayburn House Office Building
16	http://www.rapidratings.com/equivalents_scale.html