EVENTS

Date:	Tuesday, September 27, 2005
Time:	2:00 PM -- 4:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

September 2005

HR 2990:Improving the Credit Rating Industry

The Securities and Exchange Commission designates certain credit rating agencies as “nationally recognized statistical ratings organizations” (NRSROs). It has been argued that this designation inhibits competition and has effectively created a government-sponsored cartel. Currently only two firms--Standard and Poor’s and Moody’s--represent about 80 percent of sector revenue. In an effort to increase competition and improve the quality of credit ratings, Congressman Michael G. Fitzpatrick (R-Pa.) has introduced HR 2990: The Credit Rating Agency Duopoly Relief Act of 2005, cosponsored by Financial Services Committee chairman Michael Oxley (R-Ohio), Capital Markets Subcommittee chairman Richard Baker (R-La.), and eight other members of Congress. On September 27, Congressman Fitzpatrick was joined by a panel of experts to discuss the state of the credit rating industry and the possible consequences of H.R. 2990--the effect it would have on credit ratings as well as its constitutional ramifications.

Alex J. Pollock
AEI

In the debate over reforming the credit rating industry, the central issue is the Securities and Exchange Commission’s (SEC) nationally recognized statistical ratings organization (NRSRO) designation. This designation creates a government-sponsored duopoly in credit ratings. The real creativity in H.R. 2990 is that it permits the NRSRO designation to remain, but changes its meaning in a pro-competitive way.

The Honorable Michael G. Fitzpatrick
U.S. House of Representatives

Credit rating agencies have been in operation since the early twentieth century and now evaluate the likelihood of default for governments, bonds, asset-backed securities, commercial paper, certificates of deposit, and preferred stocks. These agencies have immense power on the bottom lines for schools, governments, financial institutions, and firms. In light of the fact that Moody’s and S&P gave Enron and WorldCom an investment grade rating before the scandals broke, it is clear that the industry itself merits analysis.

The SEC coined the term NRSRO in 1975 without actually defining it. The private sector proceeded to adopt the term, but still without a specific definition in place. Although the SEC attempted to clarify the term during the 1990s, the commission was unsuccessful. The SEC’s national recognition system presents an insurmountable and artificial barrier to entry. While debt issuers need credit ratings issued by an NRSRO, the SEC’s requirements and the lack of clarity in the designation process severely hinder other firms from becoming NRSROs, and thus from truly competing in the credit rating industry.

Lack of competition in the industry has led to inflated prices, stifled innovation, lower quality of ratings, and unchecked conflicts of interest. H.R. 2990 was introduced in order to foster competition, transparency, and accountability in the credit rating industry. The bill enhances investor protection by implementing a more transparent designation process. Ironically, the SEC gives investors--regardless of their sophistication--complete freedom to choose their own mutual funds. Yet the commission fails to offer similar freedom to the sophisticated actors that demand credit ratings.

H.R. 2990 would eliminate the SEC’s anti-competitive designation process. All eligible credit rating agencies would be registered with the SEC under the Securities and Exchange Act of 1934. To become eligible as a nationally registered organization, the companies must have been in the industry for three years. Also, unlike under the current system, this new definition does not discriminate against certain business models, accepting firms that use purely quantitative models. To increase investor protection, the bill mandates reporting and record-keeping requirements for registered firms, similar to those requirements borne by mutual funds and brokers. Registered rating agencies will be held accountable under the SEC and the Securities Exchange Act of 1934.

Floyd Abrams
Cahill Gordon & Reindel

The mere existence of an NRSRO designation of does not raise First Amendment issues. Yet the First Amendment does become relevant once Congress gets involved. If the NRSRO were not embodied in law, there would not be a constitutional issue. However, this proposed legislation by its very nature contains aspects that are unconstitutional.

There is a great body of law that says that reporting on financial matters is fully protected by the First Amendment; it is deemed “speech.” Reporting on financial matters involves expressing an opinion, and expressing this opinion is done in “the world’s shortest editorial,” a letter such as “A.” S&P, for instance, makes its analysis and publishes its ratings to be distributed to the public. Unsolicited ratings make credit rating agencies more “journalistic.” Thus they receive First Amendment protection. In a recent ruling in a case involving Enron, a liability action against rating agencies was dismissed on First Amendment grounds. In New York, subpoenas are frequently rejected under shield laws.

H.R. 2990 raises constitutional questions because the bill requires that agencies register with the federal government. In other words, the bill requires firms to have a license to engage in First Amendment activity. Everything in the statute deals with the power of government to register these agencies. Second, the bill would bring the SEC into the area of deciding upon the procedures and methodology of rating agencies to determine if they could or could not be licensed. This is along the same lines as the government’s forcing the Wall Street Journal to register its methods with the SEC because of the paper’s influence on financial markets.

Ted Frank
AEI

The First Amendment case against NRSROs is overstated. First, consider Lowe vs. SEC. The court found Lowe outside the purview of the Investment Advisers Act because his advice was not personalized and therefore not covered by the statute. Three concurring justices said that Lowe was covered under the act, but that the application of the act to Lowe was unconstitutional under the First Amendment. Still, even the dissenters indicated that they saw no First Amendment problem with registration or anti-fraud requirements. The outcome of this debate helps frame the question, is S&P more like a publisher or an entity that makes person-to-person transactions that can be regulated by the SEC?

Courts have ruled that licensing in and of itself is not unconstitutional. A great deal of conduct involving “speech” is regulated without violating the First Amendment. For example, in the interest of protecting the public engaged in commercial activity, the government regulates the exchange of information about securities as well as corporate proxy statements.

Moody’s and S&P are publications, but they do not have to have the NRSRO designation.

Another objection to H.R. 2990 is that the bill requires the disclosure of the methodology of credit rating agencies. However, the bill does not grant the SEC authority to actually change the methodology if it is somehow unacceptable. The disclosure process in itself does not create a First Amendment problem, and it is worth noting that Moody’s and S&P currently disclose their methodology voluntarily.

Mr. Abram’s argument against the threat of chilling because of the danger of favoritism proves too much. Under the status quo, the SEC’s designation of NRSROs is opaque. There would be less chilling if the SEC designation, and the rewards that came with it, were subject to objective standards.

The Department of Justice has argued that the SEC’s NRSRO designation has created an anticompetitive barrier to entry. Typically, it is not good policy to fix the problems of older regulations by creating new ones. But if eliminating the NRSRO designation is not feasible, one can fix the competition problems and avoid the gray areas brought up by Mr. Abrams, simply by making the designation voluntary. Agencies will voluntarily comply and there will not be a First Amendment issue. Another solution would be to change the definition of NRSRO to apply only to credit ratings sold to debt issuers, which would be a personal transaction that can be regulated.

The bill should include explicit pre-emption provisions and a bar on private causes of action, because plaintiffs’ attorneys are a pernicious and creative lot that could use the existence of a statutory duty to create liability for credit rating agencies that would be bad for the market.

Jeanne Dering
Moody’s Corporation

Moody’s Corporation supports the stated objectives of H.R. 2990: promoting healthy competition, transparency, and accountability in the credit rating industry. However, Moody’s finds that the bill has two major unintended consequences. First, it would limit the diversity of rating agency opinions, and second, it would increase rating agency contingent liability exposure.

First, H.R. 2990 would grant the SEC authority to censure rating agencies, deny them registration, or otherwise limit their activities if the commission finds their methodologies unacceptable. This sort of regulatory regime could end up encouraging or requiring that agencies follow a single methodology. This would in turn reduce competition and reduce the diversity of information within the ratings market. A better course of action would be to (1) encourage rating agencies to report on the performance of their rating systems against their stated objectives, and (2) focus on the processes and procedures that agencies have in place to ensure independence, objectivity, and proper management of potential conflicts of interest.

Second, H.R. 2990 may weaken First Amendment protections afforded to publishers of credit opinions, which would end up increasing rating agencies’ exposure to civil litigation. To allow issuers, investors, or others to bring claims against rating agencies when they disagree with individual opinions could have a chilling effect on the agencies’ willingness to continue to publish their independent opinions. In addition, erosion of the protections for the rating agencies’ privileged and confidential information could cause issuers to refrain from open and confidential discussions with rating agencies. The lack of information could reduce the overall timeliness and quality of credit ratings.

To the end of realizing the underlying goals of H.R. 2990, Moody’s advocates a voluntary arrangement to foster greater transparency and accountability for rating agencies. The International Organization of Securities Commissions (IOSCO) in December 2004 published the Code of Conduct Fundamentals for Credit Rating Agencies. This IOSCO Code could be a standard that agencies could use to voluntarily structure their own internal codes of conduct. Thus, the market would have a way to assess and measure the policies, procedures, and disclosures of the agencies.

Lawrence J. White
New York University

The SEC’s NRSRO designation has been a mistake. It restricts entry into the bond rating business, potentially discourages innovation, and distorts capital markets. There is no way of knowing if Moody’s and S&P meet a market test: are they the best bond raters, are their methods best, and are there better alternatives to the current system of formal bond ratings? Because of the lack of competition in the industry, it is impossible to know. While H.R. 2990 may improve on the status quo, it fails to address the underlying problems. Instead of defining NRSRO, the SEC should abandon the designation altogether. The financial markets can and should decide for themselves which agencies are the most reliable. In fact, the SEC could end up using H.R. 2990 as an opportunity to regulate all bond raters.

Despite the fact that the SEC never formally defined the criteria for the NRSRO designation, NRSRO is in widespread use by financial regulatory agencies. Whereas economies of scale and brand-name reputation already make it difficult for firms to compete with Moody’s and S&P, the NRSRO designation makes it even more difficult. In addition, since capital markets are forced to heed the judgments of NRSROs--even if the judgments are bad--the designation may distort capital markets.

The SEC should not respond to this problem by providing a definition for NRSRO; doing so would only entrench a bad system. There are two main options for the SEC. Option A is to eliminate the NRSRO category. The participants in the financial markets can decide for themselves which are the reliable credit rating agencies. If A is politically unfeasible, Option B would be to maintain the NRSO category but assess applicants on the basis of their outputs. The application and designation process must be transparent, and the SEC should evaluate the incumbents as well as eager competitors.

H.R. 2990 may be a modest improvement to the status quo, in that the SEC will be registering NRSROs as opposed to approving them and the commission may become more conscious of the importance of output information. However, there are substantial risks and dangers of H.R. 2990. The fact that an agency seeking the NRSRO designation needs to have been doing ratings for three years is a barrier to entry. Also, the SEC may view the authorization to adopt regulations with regard to “misuse of public information” and “management of conflicts of interest” as an opportunity to regulate all bond raters.

AEI staff assistant Dan Geary prepared this summary.