July 28, 2003
Via Electronic Mail
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609
Re: Comments on the Concept Release on Rating Agencies and the Use of
Credit Ratings under the Federal Securities Laws
(Release Nos. 33-8236; 34-47972; IC-26066; File No. S7-12-03)
Dear Mr. Katz:
We at Rating and Investment Information, Inc. ("R&I") are writing in response to the Commission's concept release regarding rating agencies and the use of credit ratings under the Federal securities laws ("Concept Release").1 R&I is headquartered in Japan and is one of the largest rating agencies in Asia. R&I is a respected independent source of financial information for the overwhelming majority of U.S. broker-dealers and financial institutions that conduct operations in Japan, and provides a variety of rating services to U.S. and foreign companies.2/ R&I's ratings are regularly announced and published by the leading financial electronic and print media in Japan, and in the U.S. as well.3/ R&I appreciates this opportunity to comment on the Concept Release. We hope that our comments will be of assistance to the Commission.
Discussion of Issues
A. Alternatives to the NRSRO Designation
The Commission should not eliminate the NRSRO designation from Commission rules, but the NRSRO designation procedures need to be improved to reduce or remove unreasonable entry barriers and to increase transparency. The NRSRO designation system itself is a necessary regulatory framework for the maintenance and development of healthy U.S. capital markets.
The use of consistent and credible ratings provided by rating companies (which are subjected to critical review by market participants) as a complement to Commission regulations (such as the net capital rule) should be respected. The use of NRSROs' ratings in the implementation of Commission regulations is the result of time-tested experiences and careful and extensive studies.
R&I does not believe there are any practicable alternatives to the current NRSRO designation. As such, any attempt to create an entirely new system or alternative would entail substantial cost and time. Moreover, such an attempt could contribute to a disruption of the healthy growth and orderly development of the capital markets.
B. Recognition Criteria
Existing Substantive Criteria
Currently, there are no clear and objective recognition criteria contained in Commission rules. Thus, appropriate recognition criteria need to be established. The informal Commission criteria employed by the Staff of the Division of Market Regulation ("Staff") which formed the crux of the five criteria proposed by the Commission in its 1997 rule proposal (the "1997 Proposal")4 are generally reasonable. The five criteria in the 1997 Proposal have been basically adopted in the draft of the New Basel Capital Accord by the Basel Committee on Banking Supervision as the eligibility criteria for an External Credit Assessment Institution. Such adoption by the Basel Committee on Banking Supervision indicates a consensus that the criteria in the 1997 Proposal are generally reasonable and acceptable.
It is appropriate to consider whether a rating agency is widely accepted as an issuer of credible and reliable ratings by the predominant users of securities ratings in the United States when determining whether to grant NRSRO recognition.
This general acceptance can be verified through attestations from and interviews with authorized officers of underwriters, dealers, banks, insurance companies and mutual funds. Also, statistical data can be used to demonstrate market reliance on an applicant's ratings. For instance, institutional investors commonly use the correlation between bond yield spread and rating as well as rating coverage to demonstrate market reliance on an applicant's ratings.
Also, although it may be an objective criterion, NRSRO recognition should not be conditioned on how widely a credit rating agency has been retained by issuers as it would raise new conflict of interest issues.
The existence of quality procedures contributes to reliable ratings, and it is appropriate for the Commission to ascertain that quality procedures do exist before granting NRSRO status. However, the Commission should be careful in terms of how closely it seeks to evaluate such procedures. It would be counterproductive for the Commission to set detailed standards, methodologies, or procedures because such requirements would be inherently inflexible and prevent rating agencies from adjusting their rating standards, procedures or methodologies in a timely and effective manner.
Disclosure by rating agencies of their rating methods and procedures would be helpful for market participants to evaluate the quality and reliability of the ratings provided by various rating agencies.
Access to and contact with the management of issuers are critically important factors in making reliable rating decisions because through interviews with issuer management analysts can examine such factors as the quality of corporate governance and strategic plans for the future. R&I believes interviews of management should be included in the rating process.
While the use of computerized statistical models can be helpful in checking or verifying the appropriateness of ratings, ratings based solely on computerized statistical models are not desirable as they may not take into account sudden changes in the economic environment or substantial modifications of accounting principles and standards.
The adequacy of a credit rating agency's staff should be considered by the Commission when determining NRSRO status; however, the Commission should not impose minimum standards for the training and qualifications of credit analysts.
R&I believes that rating companies should disclose the details regarding their human resources so that the market can make appropriate judgment as to the qualities of ratings produced by various rating companies.
This level of scrutiny would involve the Commission too deeply in the business practices of rating agencies. The best indicator of a credit rating agency's business is the quality of its ratings.
Rating agencies should not be allowed to engage in credit rating advisory services as such advisory services inherently raise conflict issues.
Other Factors to be Considered
As a general rule, there is no reason rating services of a particular rating agency should be limited to any particular sector of the debt market or any particular geographic area. At the same time, if there are rating agencies which have special strengths in a particular sector of the debt market or certain geographic areas, such rating agencies should be recognized as NRSROs so that investors in the U.S. may benefit from their analysis. For example, a rating agency such as R&I which has a long history of providing reliable risk analysis for yen-denominated securities would appropriately be granted limited NRSRO status with respect to issuers of yen-denominated securities.
R&I believes that the introduction of a provisional NRSRO status may complicate the NRSRO recognition process. To avoid such complexity, the Commission should recognize rating agencies that satisfy almost all NRSRO recognition criteria but slightly lack national recognition as a full-fledged NRSRO. As always, the most important criterion is the quality of the ratings.
Recognition of NRSROs should be accomplished through formal Commission action employing formally enacted criteria. If the Staff remains responsible for the recognition of NRSROs, the Commission should establish an appeal process.
R&I believes that the Commission should publicize applications for NRSRO recognition and seek public comment in order to ensure transparent procedures. Such a process will also allow for the participation of consumers of credit ratings who were not satisfied with the quality of a rating agency's work product.
R&I believes that the Commission should establish a time period within which it should make a determination on an application for NRSRO recognition. In general, 90 days would be appropriate. Such timelines have proved very effective in similar contexts, such as applications for NASD membership.
C. Examination and Oversight of NRSROs
As a preliminary matter, R&I believes that in order to maintain credibility and public trust in NRSROs, certain minimum oversight and review of NRSROs is necessary. However, it would have negative consequences on the activities of rating agencies if the Commission were to adopt strict and detailed standards on the way rating agencies should provide their services. Strict and inflexible regulatory standards would discourage creative development of new rating and risk analysis methods and technology. Setting rigid regulatory standards for purposes of oversight and inspection would be detrimental to the healthy development of the capital market and should be avoided. The question as to who should bear the burden of the cost associated with strict and detailed oversight must be carefully examined. In particular, whether the cost associated with oversight and compliance should be borne by investors, issuers, or tax payers should be carefully studied.
It would be appropriate and fair to regularly check if rating agencies recognized as NRSROs have been maintaining their original qualification criteria. This can be accomplished by requiring NRSROs to submit reports to the Commission indicating past performance and continuing qualification. Such submissions should be disclosed to the public.
If the Commission determines that a particular NRSRO fails to satisfy all of the necessary criteria, such rating agency should be required to immediately rectify the situation. If, after one year's probation period, such an NRSRO still fails to satisfy all of the criteria, the NRSRO recognition should be revoked.
The Commission should review an NRSRO's continuing compliance with the original qualification criteria. If there is any reason to believe that an NRSRO has failed to meet any of the original qualification criteria at any time, the Commission should be able to conduct a review of the particular NRSRO in question. The evaluation of the overall quality and performance of NRSROs generally should be deferred to market participants.
R&I believes comments and research reports on an NRSRO's performance prepared by market participants, particularly influential investors, would be valuable in terms of an NRSRO's continuing compliance with the original qualification criteria.
NRSROs should be subject to minimum oversight only to the extent necessary to verify that NRSROs are qualified to, and in fact do, issue quality ratings.
Although the Staff currently requires that NRSROs register as investment advisers, R&I believes it is not necessary to condition NRSRO recognition on registration as an investment adviser under the Advisers Act. Once a rating agency is recognized as an NRSRO, it is important for the Commission to determine the on-going satisfaction of the initial approval criteria. The best approach toward this determination would be annual Commission review as described in our answers to Questions 28 and 29. If the performance and qualifications of an NRSRO can be regularly monitored and reviewed, registration as an investment advisor is not necessary.
NRSRO recognition should not be conditioned on recordkeeping requirements. Although maintaining records relating to the rating business is necessary, there is no need to prescribe certain requirements. The Commission does not need to become too deeply involved in the inner workings of credit rating agencies whose past performance enables them to be initially and continually recognized as a provider of quality ratings.
R&I does not believe that the Commission should set any detailed standards for the performance or quality of an NRSRO's rating services. Market participants are the ultimate decision-makers in evaluating the performance of various rating agencies.
D. Conflicts of Interest
As a preliminary matter, R&I believes that the avoidance of conflicts of interest is absolutely necessary to enhance public confidence in rating agencies in general and to maintain credibility in their ratings of various debt instruments. Highest priority should be given to the elimination of any appearance of conflicts of interest in order to preserve the good reputation of rating services in capital markets as integrity and best reputation are essential to the survival of the rating industry. The erosion of public trust in the rating business in general would lead to the collapse of the industry. Nevertheless, the total prohibition of other services or business is not necessary or desirable because of the need for rating agencies to secure stable financial resources, to attract and maintain high-quality analysts, and to effectively utilize their human and other resources. Provision of rating consulting and/or rating advisory services should be barred, however, because of the direct and significant nature of the inherent conflict of interest involved in such advisory services.
Good governance, as well as independence from interested parties including shareholders, should be the most fundamental factors to avoid conflicts of interest in rating agencies. Rating agencies should adopt internal conflict avoidance systems and strict internal compliance rules. Such a compliance system and rules should include a system of checks and balances between offices and individuals having potential conflict relationships and the establishment of a compensation system for rating analysts that is independent of the revenues from issuers and others. The internal conflict avoidance system and compliance rules should be reported to the Commission and disclosed to the public.
R&I believes it is necessary for rating agencies to establish and document internal rules and procedures that address potential conflicts of interest. Analysts' compensation must be independent of the revenues from issuers and others. NRSROs also should prohibit analysts and other employees of rating agencies from investing in issuers covered by the agency.
R&I believes that NRSROs should be required to disclose existing and potential conflicts of interest when publishing ratings.
Rating analysts should not be directly involved in the solicitation of, or negotiation of compensation with, potential and existing issuers. In general, the establishment of strict firewalls between rating analysts and employees involved in solicitation and business negotiations can be an effective measure to address conflict concerns. However, so far as structured finance matters are concerned, rating analysts, mostly senior ones, with sufficient understanding of conflict issues should not be completely barred from being involved in the process of determining the appropriate level of a rating agency's compensation for providing rating services. In such determinations, the experience and knowledge of experienced rating analysts can assist rating agencies in determining the complexity (and difficulty) of the subject matter and the extent to which rating companies should be compensated. So long as the remuneration for such senior analysts is independent of the existence and/or level of compensation to be paid by the relevant companies to be rated, the concern for potential conflicts of interest can be avoided or adequately addressed.
Consulting or advisory services regarding credit ratings should be barred. Other businesses or services should not be barred as the conflict issues can be adequately addressed by establishing a conflict avoidance system, internal rules and other compliance programs, provided such other businesses or services are publicly disclosed.
There is no question that rating agencies must ensure that rating information is disclosed in a fair manner. A complete bar or prohibition of contact between rating analysts and subscribers (and other users of ratings) is not appropriate as rating analysts should be available for inquiries from the users of ratings. Analysts should be free to offer their opinion provided they do not reveal material non-public information to subscribers or users. Existing remedies to deter and punish such inappropriate disclosure are sufficient.
In general, a rating agency must have adequate financial resources and should not be heavily financially dependent on certain issuers or subscribers. However, NRSRO recognition should not be conditioned by a specific amount of financial resources.
The neutrality and independence of rating agencies can not be checked by a few numerical standards such as maximum percentage of revenues from a single source.
E. Alleged Anticompetitive, Abusive, and Unfair Practices
R&I believes that in order to ensure the fair and effective functioning of the rating services and to avoid raising entry barriers to the rating services market, anti-competitive practices by rating agencies should be strictly policed. However, the effectiveness of specifying and listing certain prohibited anticompetitive practices in the context of the Commission's NRSRO regulations is questionable as such regulations may not keep pace with rapidly changing market conditions and constantly evolving practices of rating agencies. Antitrust and fair trade authorities (such as the U.S. Department of Justice and the U.S. Federal Trade Commission) should be more closely involved in preventing (and penalizing) anticompetitive practices by rating agencies.
F. Information Flow
Generally speaking, rating agencies should strive to maintain a high level of information disclosure provided such disclosure by itself would not violate confidentiality clauses of rating contracts.
Rating agencies should disclose their standard guidelines for rating criteria as well as their view or use of various financial data and indexes in connection with their rating services in general. However, the Commission should not require the disclosure of specific assumptions and particular indexes used by rating agencies with respect to a particular rating decision. Whether to disclose such specifics regarding a particular rating decision should be left to the discretion of each rating agency provided each agency is consistent regarding the level of disclosure it makes across all ratings.
Rating agencies should periodically disclose their performance information such as default ratios and transitional rating matrix. The frequency of such disclosure should be either once or twice a year.
Results of rating decisions should be freely offered and disseminated to market participants and the public so that they may be easily used as commonly shared information. However, a rating agency should not be required to disclose rating results when there is a specific prior agreement between a rating agency and an issuer as to certain prescribed conditions for not providing or disclosing ratings, or for ceasing rating, such as: (1) where there are no ratings assigned to any financial instruments of the issuer; or (2) where the financial instruments issued by the issuer are designed to be held only by a small group of sophisticated investors.
Rating agencies should assure public notification whenever they cease rating or following an issuer because such information is important to users of ratings.
A rating agency should be permitted to cease rating when changed circumstances make it impossible or inappropriate to continue monitoring the creditworthiness of an issuer for the purpose of providing reliable ratings, but the Commission should not require disclosure of the detailed background for such action.
R&I would again like to thank the Commission for this opportunity to comment on the Concept Release. For further information or clarification regarding our comments, please feel free to contact Mr. Yasuhiro Harada at firstname.lastname@example.org or Mr. Masatami Kasagi at email@example.com.
Executive Vice President
Rating and Investment Information, Inc.
|1|| Release Nos. 33-8236, 34-47972, and IC-26066 (June 4, 2003), 68 F.R. 35258 (June 12, 2003).
|2|| R&I provides rating information services to the following U.S. financial institutions: AIG Holdings; Alliance Capital Asset Management; American Family Life Assurance Company; Bank of America Securities; Bank of America NA; Deutsche Bank Group; Bear Stearns (Japan) Ltd.; Brown Brothers Harriman & Co.; Citibank NA; Cigna International Investment; Citicorp Securities (Japan) Ltd.; Cititrust & Banking Corp.; Fidelity Investment; Credit Suisse First Boston Securities; Frank Russell Company; Franklin Templeton Investments; G. E. International Inc.; Goldman Sachs (Japan) Ltd.; J.P. Morgan Chase Bank; J.P. Morgan Investment Management Inc.; J.P. Morgan Securities.; Lehman Brothers Japan Inc.; Merrill Lynch Japan Inc.; Merrill Lynch Investment Managers; Morgan Stanley Japan Ltd.; Nikko Citigroup Limited; Prudential Life Insurance; and State Street Investment Management.
|3|| Publications by R&I include: R&I Rating Information, R&I Rating Data Quarterly, R&I Facsimile Service, and R&I Country Risk Survey. In addition, investors can access a summary (in English as well as in Japanese) of all the evaluations provided by R&I through its website, at <http://www.r-i.co.jp>. Furthermore, R&I's ratings also are made available through Reuters, Bloomberg, Quick, the FT Credit Ratings International, and other newspapers including The Nihon Keizai Shimbun and The Nikkei Weekly.
|4|| Release No. 34-39457 (December 17, 1997), 62 F.R. 68018 (December 30, 1997).