Definition of Nationally Recognized Statistical Rating Organization, 21306-21323 [05-8158]
Download as PDF
<![CDATA[
21306
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
SECURITIES AND EXCHANGE
COMMISSION
17 CFR Part 240
[Release Nos. 33–8570; 34–51572; IC–
26834; File No. S7–04–05]
RIN 3235–AH28
Definition of Nationally Recognized
Statistical Rating Organization
Securities and Exchange
Commission (‘‘Commission’’).
ACTION: Proposed rule.
AGENCY:
SUMMARY: The Commission is
publishing for comment a proposed new
rule under the Securities Exchange Act
of 1934 (‘‘Exchange Act’’), which would
define the term ‘‘nationally recognized
statistical rating organization’’
(‘‘NRSRO’’). The proposed definition
contains three components that must
each be met in order for a credit rating
agency to be an NRSRO. The
Commission is also providing
interpretations of the proposed
definition of the term ‘‘NRSRO.’’
Defining the term ‘‘NRSRO’’ and
providing interpretations of the
definition would increase transparency
with regard to the NRSRO concept.
DATES: Comments should be received on
or before June 9, 2005.
ADDRESSES: Comments may be
submitted by any of the following
methods:
Electronic Comments
• Use the Commission’s Internet
comment form (https://www.sec.gov/
rules/proposed.shtml); or
• Send an e-mail to rulecomments@sec.gov. Please include File
Number S7–04–05 on the subject line;
or
• Use the Federal eRulemaking Portal
(https://www.regulations.gov). Follow the
instructions for submitting comments.
rmajette on DSK29S0YB1PROD with PROPOSALS
Paper Comments
• Send paper comments in triplicate
to Jonathan G. Katz, Secretary,
Securities and Exchange Commission,
450 Fifth Street, NW, Washington, DC
20549–0609.
All submissions should refer to File
Number S7–04–05. This file number
should be included on the subject line
if e-mail is used. To help us process and
review your comments more efficiently,
please use only one method. The
Commission will post all comments on
the Commission’s Internet Web site
(https://www.sec.gov/rules/
proposed.shtml). Comments are also
available for public inspection and
copying in the Commission’s Public
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
Reference Room, 450 Fifth Street, NW,
Washington, DC 20549. All comments
received will be posted without change;
we do not edit personal identifying
information from submissions. You
should submit only information that
you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT:
Michael A. Macchiaroli, Associate
Director, at (202) 942–0132; Thomas K.
McGowan, Assistant Director, at (202)
942–4886; Randall W. Roy, Branch
Chief, at (202) 942–0798; Mark M. Attar,
Special Counsel, at (202) 942–0766; or
Rachael Grad, Attorney, at (202) 942–
0183, Division of Market Regulation,
Securities and Exchange Commission,
450 Fifth Street, NW., Washington, DC
20549–1001.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
II. The Development of the NRSRO Concept
A. Background
B. History of the NRSRO Concept
C. Commission Reviews of Credit Rating
Agencies
1. 1994 Concept Release
2. 1997 Rule Proposal
3. Recent Reviews of Credit Rating
Agencies
a. NRSRO Examinations
b. Credit Rating Agency Hearings
c. Report under the Sarbanes-Oxley Act of
2002
d. The 2003 NRSRO Concept Release
D. International Initiatives
III. Discussion
A. Background
B. Proposed Definition of the Term
‘‘NRSRO’’
1. The First Component
a. Publicly Available Credit Ratings
b. Issue-Specific Credit Opinions
c. Current Credit Opinions
2. The Second Component
a. General Acceptance in the Financial
Markets
b. Limited Coverage NRSROs
3. The Third Component
a. Analyst Experience and Training
b. Number of Ratings per Analyst
c. Information Sources Used in the Ratings
Process
d. Contacts with Management
e. Organizational Structure
f. Conflicts of Interest
g. Misuse of Information
h. Financial Resources
i. Standardized Rating Symbols
C. Statistical Models
D. Provisional NRSRO Status
E. Staff No-Action Process
IV. General Request for Comment
V. Paperwork Reduction Act
VI. Consideration of the Costs and Benefits of
the Proposed Rule
A. Benefits
B. Costs
VII. Consideration on Burden and Promotion
of Efficiency, Competition, and Capital
Formation
PO 00000
Frm 00002
Fmt 4701
Sfmt 4702
VIII. Consideration of Impact on the
Economy
IX. Regulatory Flexibility Act
X. Statutory Authority
I. Introduction
In June 2003, the Commission issued
a concept release (the ‘‘2003 Concept
Release’’) soliciting public comment on
various issues regarding credit rating
agencies, including whether credit
ratings should continue to be used for
regulatory purposes under the federal
securities laws, and, if so, the process of
determining whose credit ratings should
be used and the level of oversight to
apply to such credit rating agencies.1 To
address certain issues raised in response
to the 2003 Concept Release,
particularly with regard to the clarity of
whether a credit rating agency is an
NRSRO, the Commission is proposing to
define the term ‘‘NRSRO’’ in new
Exchange Act Rule 3b–10, and to
provide interpretations of that
definition. The Commission notes that
this proposal is intended only to
address the meaning of the term
‘‘NRSRO’’ as it is used by the
Commission; it does not attempt to
address many of the broader issues
raised in response to the 2003 Concept
Release.
II. The Development of the NRSRO
Concept
A. Background
Since 1975, the Commission has
relied in several significant regulatory
areas on credit ratings by rating agencies
that the markets have recognized as
credible. These ‘‘nationally recognized
statistical rating organizations,’’ or
‘‘NRSROs,’’ have typically sought a
level of comfort regarding their status as
NRSROs through the no-action letter
process.2 To date, nine firms have been
identified as NRSROs by the
Commission staff. However, during the
1990s, several credit rating agencies
consolidated so that there are currently
five such NRSROs: A.M. Best Company,
Inc. (‘‘A.M. Best’’), Dominion Bond
Rating Service Limited (‘‘DBRS’’); Fitch,
1 Securities Act Release No. 33–8236), 68 FR
35258 (June 12, 2003). The 2003 Concept Release
was intended to assist the Commission in addresing
issues identified in its January 24, 2003 report on
credit rating agencies, which was required by
Congress under Section 702 of the Arbanes-Oxley
Act of 2002. See report on the Role and Function
of Credit Rating AGencies in the operation of the
Securities Markets, As Required by Seciton 7029b)
of the Sarbanes-Oxley Act of 2002, U.S. Securities
and Exchange Commission, January 2003.
2 See, e.g., Letter from Annette L. Nazareth,
Director, Division of Market Regulation,
Commission, to Mari-Anne Pisarri, Pickard and
Djinis LLP (February 24, 2003). For a more detailed
description of the no-action letter process, see also
Section III.E.
E:\TEMP\25APP3.SGM
25APP3
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
Inc. (‘‘Fitch’’); Moody’s Investors
Service Inc. (‘‘Moody’s’’); and the
Standard & Poor’s Division of the
McGraw Hill Companies, Inc. (‘‘S&P’’).
Although the Commission originated
the use of the term ‘‘NRSRO’’ for use in
its rules and regulations, ratings by
NRSROs today are used as benchmarks
in federal and state legislation, rules
issued by financial and other regulators,
foreign regulatory schemes, and private
financial contracts. Many of these uses
specifically refer to the term ‘‘NRSRO’’
as used in the Commission’s rules and
regulations. However, the Commission
has never defined the term ‘‘NRSRO.’’
rmajette on DSK29S0YB1PROD with PROPOSALS
B. History of the NRSRO Concept
The term ‘‘NRSRO’’ was originally
adopted by the Commission in 1975
solely for use in determining capital
charges on different grades of debt
securities under Exchange Act Rule
15c3–1, the Commission’s ‘‘net capital
rule.’’ 3 The use of this term enabled the
Commission to distinguish between
investment grade and non-investment
grade paper in a reasonably objective
fashion. The net capital rule requires
broker-dealers, when computing net
capital, to deduct from their net worth
certain percentages of the market value
of their proprietary securities positions.
These deductions, often referred to as
‘‘haircuts,’’ are intended to provide a
margin of safety against losses that
might be incurred by broker-dealers as
a result of market fluctuations in the
prices of, or lack of liquidity in, their
proprietary positions. The Commission
determined that it was appropriate to
apply a lower haircut to securities held
by a broker-dealer that were rated
‘‘investment grade’’ by a credit rating
agency of national repute, because those
securities typically were more liquid
and less volatile in price than securities
that were not so highly rated.4
Over time, as marketplace and
regulatory reliance on credit ratings
increased, the Commission’s use of the
NRSRO concept as a proxy for
regulatory determinations of liquidity
and creditworthiness became more
widespread.5 Several rules and
3 See Adoption of Amendments to Rule 15c3–1
and Adoption of Alternative Net Capital
Requirement for Certain Brokers and Dealers,
Release No. 34–11497 (June 26, 1975), 40 FR 29795
(July 16, 1975).
4 See, e.g., 17 CFR 240.15c3–1(c)(2)(vi)(E), (F),
and (H).
5 The NRSRO concept is currently used in the
following Commission rules: 17 CFR 228.10(e),
229.10(c), 230.134(a)(14), 230.436(g), 239.13,
239.32, 239.33, 240.3a1–1(b)(3), 240.10b–10(a)(8),
240.15c3–1(c)(2)(vi)(E), (F) and (H), 240.15c3–
3a(b)(1)(i)(C), 240.15c3–1f(d), 240.15c3–3a, Item 14,
Note G, 242.101(c)(2), 242.102(d), 242.300(k)(3) and
(1)(3), 270.2a–7(a)(10), 270.3a–7(a)(2), 270.5b–3(c),
and 270.10f–3(a)(3).
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
regulations issued by the Commission
pursuant to the Securities Act of 1933,6
the Exchange Act,7 and the Investment
Company Act of 1940,8 utilize the term
‘‘NRSRO’’ and cross-reference to 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, and NRSRO ratings can be
used as benchmarks for establishing
minimum quality investment standards.
Under Rule 2a–7, a money market fund
is limited to investing in securities rated
by an NRSRO in the two highest ratings
categories for short-term debt (or
unrated securities of similar quality),
and there are limitations on the amount
of securities the fund can hold that are
not rated in the highest rating category
(or are not unrated securities of similar
quality).9 In addition, in regulations
adopted by the Commission under the
Securities Act of 1933, offerings of
certain nonconvertible debt, preferred
securities, and asset-backed securities
that are rated investment grade by at
least one NRSRO can be registered on
Form S–3—the Commission’s ‘‘shortform’’ registration statement—without
the issuer satisfying a minimum public
float test.10
In addition, Congress has
incorporated the term ‘‘NRSRO’’ into a
wide range of legislation.11 For
example, when Congress defined the
term ‘‘mortgage related security’’ in
6 See Regulation S–B (17 CFR 228.10) and
Regulation S–K (17 CFR 229.10); Rule 134 (17 CFR
230.134); Rule 436 (17 CFR 230.436); Form S–3 (17
CFR 239.13); Form F–2 (17 CFR 239.32); and Form
F–3 (17 CFR 239.33).
7 See Rule 3a1–1 (17 CFR 240.3a1–1); Rule 10b–
10 (17 CFR 240.10b–10); Rules 101 and 102 of
Regulation M (17 CFR 242.101 and 242.102,
respectively); and Rule 300 of Regulation ATS (17
CFR 242.300).
8 See Rule 2a–7 (17 CFR 270.2a–7); Rule 3a–7 (17
CFR 270.3a–7); Rule 5b–3 (17 CFR 270.5b–3); and
Rule 10f–3 (17 CFR 270.10f–3).
9 Under Rule 2a–7 (17 CFR 270.2–7), NRSRO
ratings are minimum requirements; fund advisers
must also make an independent determination that
the security presents ‘‘minimal credit risks.’’
10 Form S–3 (17 CFR 239.13).
11 See, e.g., 15 U.S.C. 78c(a)(41) (defining the term
‘‘mortgage related security’’); 15 U.S.C.
78c(a)(53)(A) (defining the term ‘‘small business
related security’’); and 15 U.S.C. 80a–
6(a)(5)(A)(iv)(I) (exempting certain companies from
the provisions of the Investment Company Act of
1940); Gramm-Leach-Bliley Act, Pub. L. 106–102
(1999); Transportation Equity Act for the 21st
Century, Pub. L. 105–178 (1998); Reigle Community
Development and Regulatory Improvement Act of
1994, Pub. L. 103–325 (1994); Department of
Commerce, Justice, and State, The Judiciary, and
Related Agencies Appropriations Act, FY2001, Pub.
L. 106–553 (2000); Higher Education Amendments
of 1992, Pub. L. 102–325 (1992); Housing and
Community Development Act of 1992, Pub. L. 102–
550 (1992); Federal Deposit Insurance Corporation
Improvement Act of 1991, Pub. L. 102–242 (1991);
and Financial Institutions Reform, Recovery, and
Enforcement Act of 1989, Pub. L. 101–72 (1989).
PO 00000
Frm 00003
Fmt 4701
Sfmt 4702
21307
Section 3(a)(41) of the Exchange Act,12
as part of the Secondary Mortgage
Market Enhancement Act of 1984,13 it
required, among other things, that such
securities be rated in one of the two
highest rating categories by at least one
NRSRO.
Finally, a number of other federal,
state, and foreign laws and regulations
today use the term ‘‘NRSRO.’’ For
example, the U.S. Department of
Education uses ratings from NRSROs to
set standards of financial responsibility
for institutions that wish to participate
in student financial assistance programs
under Title IV of the Higher Education
Act of 1965, as amended.14 In addition,
several state insurance codes rely on
NRSRO ratings in determining
appropriate investments for insurance
companies.15 The term ‘‘NRSRO’’ also
has been used in foreign jurisdictions.16
In 1975, when NRSRO ratings first
were incorporated in the net capital
rule, the Commission staff determined
that the ratings of S&P, Moody’s, and
Fitch were used nationally, and that the
staff would raise no questions if these
firms were utilized as NRSROs for
purposes of the net capital rule.17 Since
1975, the Commission staff has issued
NRSRO no-action letters 18 to six
additional credit rating agencies: (1)
Duff and Phelps, Inc.; 19 (2) McCarthy,
Crisanti & Maffei, Inc.; 20 (3) IBCA
Limited and its subsidiary, IBCA, Inc.; 21
12 15
U.S.C. 78c(a)(41).
L. 98–440, 101, 98 Stat. 1689 (1984).
14 20 U.S.C. 1070 et seq. and 42 U.S.C. 2751 et
seq., 34 CFR 668.15(b)(7)(ii) and (8)(ii).
15 For example, the California Insurance Code
relies on NRSRO ratings in allowing Californiaincorporated insurers to invest excess funds in
certain types of investments. See Cal. Ins. Code
1192.10.
16 See, e.g., National Instrument 71–101, The
Multijurisdicitional Disclosure System (Oct. 1,
1998) (Can.).
17 See, e.g., Letter from Gregory C. Yadley, Staff
Attorney, Division of Market Regulation,
Commission, to Ralph L. Gosselin, Treasurer,
Coughlin & Co., Inc. (November 24, 1975).
18 For a discussion of the no-action letter process,
see Section III.E.
19 See Letter from Nelson S. Kibler, Assistant
Director, Division of Market Regulation,
Commission, to John T. Anderson, Esquire, Lord,
Bissell & Brook, on behalf of Duff & Phelps, Inc.
(February 24, 1982).
20 See Letter from Michael A. Macchiaroli,
Assistant Director, Division of Market Regulation,
Commission, to Paul McCarthy, President,
McCarthy, Crisanti & Maffei, Inc. (September 13,
1983).
21 See Letter from Michael A. Macchiaroli,
Assistant Director, Division of Market Regulation,
Commission, to Robin Monro-Davies, President,
IBCA Limited (November 27, 1990) and Letter from
Michael A. Macchiaroli, Assistant Director,
Division of Market Regulation, Commission, to
David L. Lloyd, Jr., Dewey Ballentine, Bushby,
Palmer & Wood (October 1, 1990).
13 Pub.
E:\TEMP\25APP3.SGM
25APP3
21308
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
(4) Thomson BankWatch, Inc.; 22 (5)
DBRS; 23 and (6) A.M. Best.24 With the
exception of A.M. Best and DBRS, each
of these additional firms has since
merged with or been acquired by other
NRSROs, resulting in five NRSROs at
present.
The Commission has not adopted a
definition of the term ‘‘NRSRO.’’
However, through experience from the
no-action process, the Commission staff
has developed a number of criteria that
it considers when reviewing NRSRO noaction requests. As a result, under
current practice, the Commission staff
reviews a credit rating agency’s
operations, position in the marketplace,
and other specific factors to determine
whether to grant a no-action letter.
In determining whether to issue an
NRSRO no-action letter, the
Commission staff has considered the
single most important factor to be
whether the credit rating agency is
‘‘nationally recognized’’ in the United
States as an issuer of credible and
reliable ratings by the predominant
users of securities ratings. The notion of
‘‘national recognition’’ was designed to
help ensure that credit ratings used for
regulatory purposes under Commission
rules are credible and can reasonably be
relied upon by the marketplace. Also
reviewed in connection with the noaction letter process is a credit rating
agency’s operational capability and
ratings process. Included within this
assessment are: (1) The organizational
structure of the credit rating agency; (2)
the credit rating agency’s financial
resources; (3) the size and quality of the
credit rating agency’s staff; (4) the credit
rating agency’s independence from the
companies it rates; (5) the credit rating
agency’s rating procedures; and (6)
whether the credit rating agency has
internal procedures to prevent the
misuse of nonpublic information and
whether those procedures are followed.
C. Commission Reviews of Credit Rating
Agencies
rmajette on DSK29S0YB1PROD with PROPOSALS
1. 1994 Concept Release
Over the years, the Commission has
reviewed a number of issues regarding
credit rating agencies, including their
regulatory oversight. In 1994, the
22 See Letter from Michael A. Macchiaroli,
Assistant Director, Division of Market Regulation,
Commission, to Gregory A. Root, President,
Thomson BankWatch, Inc. (August 6, 1991) and
Letter from Michael A. Macchiaroli, Associate
Director, Division of Market Regulation,
Commission, to Lee Pickard, Pickard and Djinis LLP
(January 25, 1999).
23 See supra note 2.
24 See Letter from Mark M. Attar, Special Counsel,
Division of Market Regulation, Commission, to
Arthur Snyder, President, A.M. Best (March 3,
2005).
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
Commission issued a concept release
soliciting public comment on the
Commission’s use of NRSRO ratings (the
‘‘1994 Concept Release’’).25 Due to the
expanded role played by credit ratings
in Commission rules and regulations, a
number of domestic and foreign credit
rating agencies at that time had sought
NRSRO no-action letters. Also, concerns
had been expressed that Commission
rules and regulations did not define the
term ‘‘NRSRO,’’ and that there was no
formal mechanism for monitoring the
activities of NRSROs. As a result, the
Commission solicited public comment
on the appropriate role of credit ratings
in the federal securities laws, and the
need to establish formal procedures for
identifying NRSROs and monitoring
their activities. Most commenters
supported the continued use of the
NRSRO concept and recommended that
the Commission adopt a formalized
process for identifying NRSROs.26
2. 1997 Rule Proposal
As a response to the 1994 Concept
Release, the Commission, in 1997,
proposed to amend the net capital rule
to define the term ‘‘NRSRO.’’ 27 The
proposed amendments set forth criteria
to be considered by the Commission in
recognizing credit rating agencies as
NRSROs, and would have established
an NRSRO application process for credit
rating agencies.
Although commenters generally
supported the Commission’s attempt to
define the requirements necessary for a
credit rating agency to be identified as
an NRSRO, the Commission did not act
upon the 1997 rule proposal described
above as a result of, among other things,
the initiation of broad-based
Commission and Congressional reviews
of credit rating agencies.
3. Recent Reviews of Credit Rating
Agencies
More recently, the Commission has
pursued several approaches to conduct
a thorough and meaningful study of the
use of credit ratings in the federal
securities laws, the process of
determining which credit ratings should
be used for regulatory purposes, and the
level of oversight to apply to credit
rating agencies. Commission efforts
included discussions with credit rating
agencies and market participants,
25 See Nationally Recognized Statistical Rating
Organizations, Release No. 34–34616 (August 31,
1994), 59 FR 46314 (September 7, 1994).
26 See, e.g., Letter from Walter J. Schroeder,
President, DBRS, to Jonathan G. Katz, Secretary,
Commission (December 20, 1994).
27 See Capital Requirements for Brokers or Dealers
Under the Securities Exchange Act of 1934, Release
No. 34–39457 (December 17, 1997), 62 FR 68018
(December 30, 1997).
PO 00000
Frm 00004
Fmt 4701
Sfmt 4702
including buy-side firms,28 formal
examinations of each of the NRSROs,
and public hearings that offered a broad
cross-section of market participants the
opportunity to communicate their views
on credit rating agencies and their role
in the capital markets.
a. NRSRO Examinations
On March 19, 2002, the Commission
issued an Order directing investigation,
pursuant to Section 21(a) of the
Exchange Act, into the role of credit
rating agencies in the U.S. securities
markets.29 The purpose of the Order was
to ascertain facts, conditions, practices,
and other matters relating to the role of
credit rating agencies in the U.S.
securities markets, and to aid the
Commission in assessing whether to
continue to use credit ratings in its rules
and regulations under the federal
securities laws and, if so, the categories
of acceptable credit ratings and the
appropriate level of regulatory
oversight.
The Commission’s examination of the
NRSROs revealed several concerns,
including those relating to: (i) Potential
conflicts of interest caused by payment
by issuers to NRSROs for their ratings;
(ii) exacerbation of those conflicts of
interest due to the marketing by the
NRSROs of ancillary services to issuers,
such as pre-rating assessments and
corporate consulting; (iii) the potential
for the NRSROs, given their substantial
power in the marketplace, to improperly
pressure issuers to pay for ratings; (iv)
the potential for the NRSROs, given
their substantial power in the
marketplace, to improperly pressure
issuers to purchase ancillary services;
(v) the effectiveness of the NRSROs’
existing policies and procedures
designed to protect confidential
information; and (vi) difficulties in the
Commission’s examinations of NRSROs
from, among other things, the lack of
recordkeeping requirements tailored to
NRSRO activities, the NRSROs’
assertions that the document retention
and production requirements of the
Investment Advisers Act of 1940 are
inapplicable to the credit rating
business, and their claims that the First
Amendment shields the NRSROs from
producing certain documents to the
Commission.
28 Retail investor participation in the debt markets
often takes place indirectly through buy-side firms,
such as investment companies.
29 See Order In the Matter of the Role of Rating
Agencies in the U.S. Securities Markets Directing
Investigation Pursuant to Section 21(a) of the
Securities Exchange Act of 1934, and Designating
Officers for Such Designation (March 19, 2002).
E:\TEMP\25APP3.SGM
25APP3
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
rmajette on DSK29S0YB1PROD with PROPOSALS
b. Credit Rating Agency Hearings
The Commission’s broad-based study
of credit rating agencies included public
hearings held on November 15 and 21,
2002, that addressed credit rating
agencies operating in U.S. securities
markets.30 Panel participants
represented various views, including
those of credit rating agencies, brokerdealers, buy-side firms, issuers, and the
academic community.
Topics addressed during the hearings
included the current role and
functioning of credit rating agencies,
information flow in the credit rating
process, concerns regarding credit rating
agencies (e.g., potential conflicts-ofinterest), and the regulatory treatment of
credit rating agencies (including
concerns regarding potential barriers to
entry).
Most hearing participants favored the
regulatory use of credit ratings issued by
NRSROs as a simple, efficient
benchmark of credit quality, and
suggested that regulatory standards for
NRSROs were necessary for this concept
to have meaning and reliability.31
Many participants expressed concern
about the existing NRSRO no-action
letter process.32 Suggestions to improve
the process included (i) that the
Commission should specify the
information credit rating agencies
should provide when requesting NRSRO
no-action letters; and (ii) that the
Commission review the staff’s work in
evaluating satisfaction of the NRSRO
criteria.33 Some suggested that NRSRO
no-action requests be completed in a
more timely fashion and some noted
that the Commission might promote
competition in the credit rating industry
by explicitly permitting credit rating
agencies that specialize in particular
sectors to receive NRSRO no-action
letters.34
Some ratings users and issuers
suggested that the Commission consider
30 The Current Role and Function of Credit Rating
Agencies in the Operation of the Securities Markets,
Hearings Before the U.S. Securities and Exchange
Commission (November 15 and 21, 2002) (‘‘SEC
Hearing on Credit Rating Agencies’’). Full hearing
transcripts are available on the Commission’s Web
site at https://www.sec.gov/spotlight/
ratingagency.htm [hereinafter ‘‘SEC Hearing
Transcript’’].
31 See, e.g., SEC Hearing Transcript, supra note 30
(November 15, 2002) (testimony of Gregory A. Root,
Executive Vice President, DBRS).
32 See, e.g., Written Statement of Paul Saltzman,
Executive Vice President and General Counsel, The
Bond Market Association), SEC Hearing on Credit
Rating Agencies, supra note 30 (November 21,
2002).
33 Id.
34 See, e.g., Written Statement of Yasuhiro
Harada, Senior Executive Managing Director, Rating
and Investment Information, Inc., SEC Hearing on
Credit Rating Agencies, supra note 30 (November
21, 2002).
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
more substantive regulation of credit
rating agencies (e.g., to address potential
conflicts of interest), and engage in more
active oversight of them (e.g.,
monitoring compliance with the NRSRO
criteria).35
Concerns were raised by hearing
participants regarding the special access
of subscribers to credit rating agency
personnel, particularly given the
exclusion from Regulation FD available
for disclosures to credit rating
agencies.36 While the larger credit rating
agencies make ratings and the basic
rating rationale available
simultaneously to subscribers and nonsubscribers, subscribers may also have
direct access to credit rating agency
analysts.37 Because of this direct access,
there is a greater risk that nonpublic
material information may be
communicated to subscribers.
c. Report Under the Sarbanes-Oxley Act
of 2002
Coincident with these Commission
initiatives, Congress in Section 702 of
the Sarbanes-Oxley Act of 2002,
required that the Commission conduct a
study of credit rating agencies and
submit a report on that study to the
President and Congress (the ‘‘Report’’).
The Commission submitted the Report
to the President and Congress on
January 24, 2003.38 The Report
addressed, among other things, each of
the topics identified for Commission
study in Section 702, including the role
of credit rating agencies and their
importance to the securities markets,
impediments faced by credit rating
agencies in performing that role,
35 See, e.g., Written Statement of Amy Lancellotta,
Senior Counsel, Investment Company Institute, SEC
Hearing on Credit Rating Agencies, supra note 30
(November 21, 2002).
36 See, e.g., SEC Hearing Transcript, supra note 30
(November 15, 2002) (testimony of Malcolm S.
Macdonald, Vice President—Finance and Treasurer,
Ford Motor Company). See also Selective
Disclosure and Insider Trading, Release No. 34–
43154 (August 15, 2000), 65 FR 51716 (August 24,
2000). Generally, Regulation FD prohibits an issuer
of securities, or persons acting on behalf of the
issuer, from communicating material nonpublic
information to certain enumerated persons—in
general, securities market professionals or others
who may use the information for trading—unless
the information is publicly disclosed. When
Regulation FD was adopted, the Commission
exempted credit rating agencies—not just
NRSROs—from Regulation FD, on the condition
that the material nonpublic information is
communicated to a credit rating agency solely for
the purpose of developing a credit rating and that
the rating is publicly available. In addition to the
specific rating agency exemption in Regulation FD,
credit rating agencies may be able to avail
themselves of the exemption for ‘‘persons who
expressly agree to maintain the disclosed
information in confidence.’’ 17 CFR
243.100(b)(2)(ii).
37 Id.
38 See supra note 1.
PO 00000
Frm 00005
Fmt 4701
Sfmt 4702
21309
measures to improve information flow
to the market from credit rating
agencies, barriers to entry into the credit
rating business, and conflicts of interest
faced by credit rating agencies.39
d. The 2003 NRSRO Concept Release
To further assist the Commission in
addressing issues identified in the
Report, the Commission published the
2003 Concept Release on June 4, 2003,
seeking comment on a number of issues
relating to credit rating agencies. These
issues included whether credit ratings
should continue to be used for
regulatory purposes under the federal
securities laws, and, if so, the process of
determining whose credit ratings should
be used, and the level of oversight to
apply to such credit rating agencies.
Issues discussed during the
Commission’s two days of public
hearings on credit rating agencies were
also addressed in the 2003 Concept
Release.
Most of the 46 commenters
responding to the 2003 Concept Release
supported retention of the NRSRO
concept. They generally represented
that, among other things, eliminating
the NRSRO concept would be disruptive
to the capital markets,40 and would be
costly and complicated to replace.41
Only four commenters supported
elimination of the concept,42 and there
was limited discussion of regulatory
alternatives.43
Most commenters supported
improving the clarity of the process for
identifying NRSROs to the extent credit
ratings continue to be relied upon in
Commission rules. Specifically,
commenters generally supported the
Commission’s suggestions to specify
more detail in what credit rating
agencies need to provide to obtain an
NRSRO no-action letter.44 Some also
generally supported greater
transparency regarding the NRSRO
concept, for example, by identifying
39 Sarbanes-Oxley Act of 2002, Pub. L. 107–204,
Section 702(b), 116 Stat. 745 (2002).
40 See, e.g., Letter from Leo C. O’Neill, President,
Standard & Poor’s, to Jonathan G. Katz, Secretary,
Commission (July 28, 2003).
41 See, e.g., Letter from Gregory V. Serio,
Superintendent, New York Insurance Department,
Chair, NAIC Rating Agency Working Group,
National Association of Insurance Commissioners,
to Commission (July 28, 2003).
42 See, e.g., Letter from Lawrence J. White,
Professor of Economics, Stern School of Business,
New York University, to Commission (July 25,
2003).
43 See, e.g., Letter from Frank Partnoy, University
of San Diego School of Law, to Jonathan G. Katz,
Secretary, Commission (July 28, 2003).
44 See, e.g., Letter from Barbara Roper, Director of
Investor Protection, Consumer Federation of
America, to Jonathan G. Katz, Secretary,
Commission (July 28, 2003).
E:\TEMP\25APP3.SGM
25APP3
21310
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
NRSROs through Commission action
versus the existing no-action letter
process.45
A few commenters represented that
the current NRSRO criteria, as set forth
in the 2003 Concept Release, create
barriers to entry for new entrants and
that the standards for determining
NRSRO status should be lowered.46
Others disagreed and represented that
the current NRSRO criteria should not
be diluted.47 Most commenters
supported NRSRO criteria designed to
limit conflicts of interest in the credit
rating business.48 There was also
general support for recognizing credit
rating agencies that confine their
activities to a limited sector of the debt
market 49 or a limited geographic area.50
Most commenters supported the
concept of regulatory oversight of
NRSROs, at a minimum, to determine
whether a credit rating agency continues
to meet the NRSRO criteria on an
ongoing basis.51 Commenters also
recommended that NRSROs should be
subject to periodic Commission
examinations.52
rmajette on DSK29S0YB1PROD with PROPOSALS
D. International Initiatives
In recent years, there have also been
several international initiatives
involving credit rating agencies. In
February 2003, the Technical
Committee of the International
Organization of Securities Commissions
(‘‘IOSCO’’),53 of which the Commission
is a member, created a task force to
study issues concerning credit rating
agencies, and in September 2003 IOSCO
published ‘‘Principles Regarding the
45 See, e.g., Letter from Steven C. Nelson, Director
of Taxable Money Market Research, Fidelity
Investments Money Management, Inc., to Jonathan
G. Katz, Secretary, Commission (July 25, 2003).
46 See, e.g., Letter from LACE Financial Corp.
(July 25, 2003).
47 See, e.g., Letter from Grace Hinchman, Senior
Vice President, Public Affairs, Financial Executives
International, to Jonathan G. Katz, Secretary,
Commission (July 25, 2003).
48 See, e.g., Letter from John M. Ramsey, Senior
Vice President and Regulatory Counsel, The Bond
Market Association, to Jonathan G. Katz, Secretary,
Commission (July 28, 2003).
49 See, e.g., Letter from Jeffrey P. Neubert,
President and CEO, The New York Clearing House
Association L.L.C., to Jonathan G. Katz, Secretary,
Commission (July 31, 2003).
50 See, e.g., Letter from Naohiko Matsuo, Director
for International Financial Markets, Financial
Services Agency, Government of Japan, to Jonathan
G. Katz, Secretary, Commission (July 25, 2003).
51 See, e.g., Letter from Amy B.R. Lancellotta,
Senior Counsel, Investment Company Institute, to
Jonathan G. Katz, Secretary, Commission (July 28,
2003).
52 See, e.g., supra note 41.
53 IOSCO consists of 175 securities market
regulators that have agreed to cooperate in order to
promote high standards of regulation and to
maintain efficient and sound domestic and
international securities markets.
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
Activities of Credit Rating Agencies,’’ 54
a set of high-level objectives for
regulators, credit rating agencies, and
other market participants. In February
2004, the IOSCO Technical Committee
formed a Chairmen’s Task Force for the
purpose of developing a voluntary code
of conduct for credit rating agencies
providing guidance on ways credit
rating agencies could implement the
Principles in practice, leading to the
December 2004 publication by IOSCO of
a ‘‘Code of Conduct Fundamentals for
Credit Rating Agencies.’’ 55 The Code,
among other things, addresses how
credit rating agencies can protect their
analytical independence, eliminate or
manage conflicts of interest, and help
ensure the confidentiality of nonpublic
information shared with them by
issuers.
III. Discussion
A. Background
The Commission is proposing to
define the term ‘‘NRSRO’’ in new
Exchange Act Rule 3b–10. The proposed
definition would be composed of three
components, which the Commission
preliminarily believes to be the most
important criteria in determining
whether an entity’s ratings should be
relied upon for purposes of the
securities laws and Commission rules
and regulations. In addition, the
Commission is providing interpretations
of the proposed definition.
Specifically, the Commission is
proposing to define the term ‘‘NRSRO’’
as an entity (i) that issues publicly
available credit ratings that are current
assessments of the creditworthiness of
obligors with respect to specific
securities or money market instruments;
(ii) is generally accepted in the financial
markets as an issuer of credible and
reliable ratings, including ratings for a
particular industry or geographic
segment, by the predominant users of
securities ratings; and (iii) uses
systematic procedures designed to
ensure credible and reliable ratings,
manage potential conflicts of interest,
and prevent the misuse of nonpublic
information, and has sufficient financial
resources to ensure compliance with
those procedures.
The components of the proposed
definition are designed to determine
those credit rating agencies whose
54 ‘‘IOSCO Statement of Principles Regarding the
Activities of Credit Rating Agencies,’’ The
Technical Committee, IOSCO (September 25, 2003).
See also ‘‘Report on the Activities of Credit Rating
Agencies,’’ The Technical Committee, IOSCO
(September 2003).
55 See ‘‘Code of Conduct Fundamentals for Credit
Rating Agencies,’’ The Technical Committee of
IOSCO (December 2004).
PO 00000
Frm 00006
Fmt 4701
Sfmt 4702
ratings are sufficiently reliable to be
used for a variety of regulatory
purposes, such as for purposes of the
net capital rule. For example, the
principal purposes of the net capital
rule are to protect customers and other
market participants from broker-dealer
failures and to enable those firms that
fall below the minimum net capital
requirements to liquidate in an orderly
fashion without the need for a formal
proceeding or financial assistance from
the Securities Investor Protection
Corporation. The net capital rule
requires different minimum levels of
capital based upon the nature of the
firm’s business and whether the brokerdealer handles customer funds or
securities. In relying on credit ratings
believed to be sufficiently reliable, the
Commission is using those ratings as a
means to evaluate the liquidity as well
as the creditworthiness of certain
securities held by a broker-dealer in
establishing a sufficient capital cushion.
B. Proposed Definition of the Term
‘‘NRSRO’’
1. The First Component
The first component of the proposed
NRSRO definition would limit the
definition to entities that issue publicly
available credit ratings that are current
assessments of the creditworthiness of
obligors with respect to specific
securities or money market instruments.
a. Publicly Available Credit Ratings
In the 2003 Concept Release, the
Commission inquired whether it should
address concerns that certain credit
rating agencies make their 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
ratings for regulatory purposes. The
majority of commenters agreed that
credit rating agencies whose ratings are
used for regulatory purposes under the
Commission’s rules and regulations
should agree to make public
dissemination of their ratings on a
widespread basis at no cost.56
Commenters generally represented
that the publication of credit ratings (i)
enhances the transparency and
efficiency of the market, (ii) helps
prevent potential selective disclosure of
material nonpublic information
obtained by a credit rating agency under
Regulation FD, and (iii) and allows for
56 See, e.g., Letter from Denise Voigt Crawford,
Securities Commissioner, Texas State Securities
Board, to Jonathan G. Katz, Secretary, Commission
(July 28, 2003).
E:\TEMP\25APP3.SGM
25APP3
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
rmajette on DSK29S0YB1PROD with PROPOSALS
ratings comparability.57 The
commenters also said that a credit rating
should not be considered to be
‘‘publicly disseminated’’ if access to it is
not readily available on a widespread
basis.58
One commenter noted that a credit
rating agency should not be required to
disclose ratings to the public when there
is a specific prior agreement between
the credit rating agency and an issuer as
to certain prescribed conditions for not
publishing the issuer’s rating (e.g., in
the case of ‘‘private’’ ratings, in which
a credit rating agency agrees to provide
its rating of an issuer only to the
issuer).59 Another commenter suggested
that NRSROs should permit others, such
as publishers of financial information,
to freely distribute new rating
information without limitations.60 One
commenter also cautioned the
Commission against involving itself in
the determination of an NRSRO’s
pricing models.61 This commenter
represented that NRSROs should be
allowed to charge whatever price the
market will bear.62 Another commenter
expressed concern that requiring
NRSROs to publish their credit ratings
at no cost may result in higher prices for
issuers and others who pay for an
NRSRO’s services.63
In response to these comments, the
Commission is proposing that, in order
to meet the definition of the term
‘‘NRSRO,’’ a credit rating agency must
issue credit ratings that are publicly
available. The Commission is also
interpreting ‘‘publicly available,’’ as
used in the definition, to mean that
credit ratings used for regulatory
purposes under Commission rules must
be disseminated on a widespread basis
at no cost. In this context, the rating
could be published in a readily
accessible manner on the credit rating
agency’s internet Web site. The
Commission believes that it is important
for credit ratings used for regulatory
57 See, e.g., Letter from Raymond McDaniel,
President, Moody’s, to Jonathan G. Katz, Secretary,
Commission (July 28, 2003).
58 Id.
59 See, e.g., Letter from Yasuhiro Harada,
Executive Vice President, Rating and Investment
Information, Inc., to Jonathan G. Katz, Secretary,
Commission (July 28, 2003).
60 See, e.g., Letter from David Colling, Product
Director, ABS Reports (UK) Limited), to Jonathan G.
Katz, Secretary, Commission (July 31, 2003).
61 See, e.g., Letter from James A. Kaitz, President
and CEO, Association for Financial Professionals, to
Jonathan G. Katz, Secretary, Commission (July 28,
2003).
62 Id.
63 See, e.g., Letter from Richard Raeburn, Chief
Executive, and John Grout, Technical Director, The
Association of Corporate Treasurers, United
Kingdom, to Jonathan G. Katz, Secretary,
Commission (August 8, 2003).
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
purposes to be publicly available, as
public availability—at no cost—should
assure wide dissemination of ratings
and provide the opportunity for the
marketplace to judge the credibility and
reliability of an entity’s credit ratings.
This approach is consistent with the
views of most commenters 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. The
Commission notes that in proposing to
define the term ‘‘NRSRO’’ as an entity
that makes its credit ratings publicly
available, the public availability
reference only would apply to the credit
rating itself (i.e., the rating symbol), and
not to other information otherwise
developed by the credit rating agency
(e.g., the credit rating agency’s rating
rationale). This approach should not
result in NRSROs charging higher fees
for their services because it would not
require a credit rating agency to make
available at no cost the analysis
underlying its rating.64 The Commission
notes that this approach is also
consistent with the current practices of
many credit rating agencies, including
each of the current NRSROs, that
already publish their credit ratings on a
widespread basis at no cost.
Questions: How should it be
determined whether an NRSRO is
making its credit ratings readily
available on a widespread basis? Should
our rule specify the manner and
methods that must be used to distribute
ratings? Should internet posting itself be
sufficient?
b. Issue-Specific Credit Opinions
The Commission is aware that credit
rating agencies often issue different
types of credit ratings that can reflect,
among other things, the
creditworthiness of specific securities or
obligations, or the general
creditworthiness of specific entities.
Because the Commission’s regulatory
use of the term ‘‘NRSRO’’ primarily
64 In connection with the Commission’s review of
issues concerning credit rating agencies,
commenters have consistently represented that they
typically subscribe to a rating agency’s services
primarily to understand the analysis underlying the
rating agency’s ratings—not solely for the credit
rating itself. For example, during the Commission’s
2002 credit rating agency hearings, representatives
of users of credit ratings (e.g., from mutual fund
companies and broker-dealers) indicated that they
review research that is done by credit rating
agencies to assess credit risk for the securities they
purchase within their portfolios. See, e.g., SEC
Hearing Transcript, supra note 30 (November 15,
2002) (testimony of Deborah A. Cunningham,
Senior Vice President and Senior Portfolio Manager,
Federated Investors, Inc., and testimony of Cynthia
L. Strauss, Director of Taxable Bond Research,
Fidelity Investments Money Management, Inc.).
PO 00000
Frm 00007
Fmt 4701
Sfmt 4702
21311
relates to credit ratings on specific
securities or obligations, the
Commission, in its proposed definition
of the term ‘‘NRSRO,’’ is limiting the
availability of the NRSRO concept to
entities that issue such ratings.
The Commission is proposing to
clarify this element of the proposed
NRSRO definition because credit rating
agencies that do not issue credit ratings
on specific securities, but instead issue
credit ratings on the general
creditworthiness of specific entities,
have requested NRSRO no-action relief.
The risk of loss on different debt
instruments of the same issuer can vary
considerably depending on the terms
written into a security’s legal
documentation. Therefore, applying a
single ‘‘issuer’’ rating to all of an issuer’s
outstanding debt instruments could be
misleading, in the context of the
regulatory use of NRSRO ratings, and
have adverse regulatory implications.
Questions: Should a credit rating
agency that does not rate specific
securities or money market instruments
be included in the definition of NRSRO?
If so, under what circumstances?
c. Current Credit Opinions
The proposed definition also attempts
to ensure that only ‘‘current’’ credit
ratings—meaning that such ratings are
actively monitored and updated
appropriately on a continuous basis—be
used for regulatory purposes under the
federal securities laws. The Commission
believes that credit ratings used for
regulatory purposes should be actively
monitored on a continuous basis and
confirmed, upgraded, or downgraded, if
and when necessary. The Commission’s
reliance on credit ratings from a credit
rating agency that are not current, and
thus, may not even reflect the credit
rating agency’s own view as to the
creditworthiness of a security, could
interfere with the intended regulatory
uses of the NRSRO rating.
The first component of the proposed
definition would require a credit rating
agency to issue credit ratings that are
‘‘current assessments’’ of the
creditworthiness of specific securities or
money market instruments. This
component may help to ensure that
persons relying on a rating for
regulatory purposes in Commission
rules and regulations can have
confidence, at any given time, that the
rating reflects the credit rating agency’s
current view.
Under the proposed definition, the
Commission would interpret ‘‘current
assessments’’ to mean that a credit
rating agency’s published credit ratings
reflect its opinion as to the
creditworthiness of a security or money
E:\TEMP\25APP3.SGM
25APP3
21312
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
market instrument as of the time the
rating was issued and until the rating is
changed or withdrawn. Under this
interpretation, a credit rating agency
could meet the ‘‘current assessments’’
element of the proposed definition if it
has and follows procedures designed to
ensure that its ratings are reviewed and,
if necessary, updated on the occurrence
of material events, including significant
sector or issue-specific events. By
including in the NRSRO definition that
a credit rating agency’s ratings need to
be ‘‘current assessments,’’ the
Commission is responding to comments
received in response to the 2003
Concept Release that a requirement that
NRSRO ratings be kept ‘‘current’’ is
desirable.65
Further, although the Commission is
proposing to define the term ‘‘NRSRO’’
to require an NRSRO’s ratings to be
current, the Commission is not
proposing to prescribe a specific time
period within which an NRSRO’s
ratings would need to be updated.
Specifying a time period within which
a credit rating agency must update or
affirm a rating might be problematic
because the appropriate time period for
responding to a material event may vary
considerably based on, for example, the
complexity of an issuer or the specific
security being rated. Accordingly, it
may be appropriate for a credit rating
agency to have the flexibility to respond
to material events relating to its ratings
on a case-by-case basis. This approach
responds to comments that the
Commission should not set detailed
standards as to when a rating agency
should update its ratings.66
Questions: Should the Commission
provide additional interpretation
regarding what it means for a credit
rating agency’s credit ratings to be
‘‘current assessments’’? Should the
Commission specify the time period?
Will the proposed rule’s provisions
provide sufficient assurance to the
markets that ratings are current?
rmajette on DSK29S0YB1PROD with PROPOSALS
2. The Second Component
a. General Acceptance in the Financial
Markets
As discussed above, the notion that a
credit rating agency be ‘‘nationally
recognized’’ for purposes of the NRSRO
concept was designed to ensure that
credit ratings used for regulatory
purposes are credible and reliable, and
are reasonably relied upon by the
marketplace. Responding to most
commenters to the 2003 Concept
Release that NRSRO status should be
based primarily on a credit rating
65 See,
66 See,
e.g., supra note 63.
e.g., supra note 59.
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
agency’s wide acceptance in the
marketplace, the second proposed
component of the ‘‘NRSRO’’ definition
focuses on whether a credit rating
agency is generally accepted in the
financial markets as an issuer of
credible and reliable ratings by the
predominant users of securities ratings.
The Commission is proposing that the
second component of the NRSRO
definition require a credit rating agency
to be generally accepted in the financial
markets. Such acceptance would reflect
the markets’ belief in the credibility and
reliability of the ratings provided by the
credit rating agency and should provide
some level of assurance to those relying
on ratings with regard to the
dependability and consistency of the
ratings for a variety of regulatory
purposes. For example, net capital
calculations and haircuts that are
determined through use of these credit
ratings are more likely to be reliable
than those determined without the use
of such ratings and, thus, could be more
likely to protect customers and other
market participants from harm in the
event of a broker-dealer failure.
Further, linking the evaluation of a
credit rating agency’s ratings to the
views of the predominant users of
securities ratings would be helpful.
Predominant users generally include
financial market participants who hold
large inventories of proprietary debt
securities, preferred stock, and
commercial paper, such as brokerdealers, mutual funds, pension funds,
and insurance companies. These firms—
given their large inventories of rated
fixed income securities—generally have
developed sophisticated internal credit
rating departments which rate issuers
and counterparties. However, they also
rely on external ratings from credit
rating agencies to compare against and
test their internal rating and analysis.
Given the importance of credit ratings to
the business of these market
participants, and to the stability of the
financial markets as a whole, the
Commission believes that incorporating
their views into the definition of
NRSRO provides a certain level of
credibility and reliability to NRSRO
ratings.
The Commission proposes that a
credit rating agency could meet the
second component of the NRSRO
definition through a variety of objective
means. For example, in appropriate
circumstances, a credit rating agency
could do so through statistical data that
demonstrates market reliance on the
credit rating agency’s ratings (e.g.,
market movements in response to
ratings changes). A credit rating agency
also might be able to satisfy the second
PO 00000
Frm 00008
Fmt 4701
Sfmt 4702
component if authorized officers of
users of securities ratings representing a
substantial percentage of the relevant
market attest that the credit rating
agency’s ratings are credible and
actually relied on by the users.
Questions: How else could the
Commission define the term ‘‘NRSRO’’
in order for users of a credit rating
agency’s ratings to determine whether
such ratings are credible and are
reasonably relied upon by the
marketplace? Are the approaches
discussed above useful for determining
whether a credit rating agency meets the
second component of the proposed
definition? Are there other types of
information that would be appropriate?
For example, should the fact that a
credit rating agency has many
subscribers support a finding that the
credit rating agency satisfies the second
component? What types of statistical
data could be relied on to determine if
a credit rating agency’s credit ratings are
relied on by the marketplace? What
standards should be considered to
assess such statistical data? Should the
views of issuers be a relevant
consideration in determining whether a
credit rating agency meets the second
component of the NRSRO definition?
b. Limited Coverage NRSROs
Commenters at both the Commission’s
credit rating agency hearings and
responding to the 2003 Concept Release
generally supported the idea that the
definition of the term ‘‘NRSRO’’ could
include credit rating agencies that
confine their activities to limited sectors
of the debt market or to limited (or
largely non-U.S.) geographic areas.
While several commenters suggested
that the Commission distinguish
between full- and limited-coverage
NRSROs,67 others represented that
credit rating agencies should only be
able to meet the definition as fullcoverage NRSROs because, in their
view, it would be difficult for limited
coverage NRSROs to provide a full and
accurate assessment of credit risks
without a broader expertise in credit
risk assessment.68
Based on the staff’s experience in
issuing no-action letters to credit rating
agencies, a credit rating agency that has
developed a general acceptance in the
financial markets for a limited sector of
the debt market or a limited geographic
area could meet the NRSRO definition.
As noted in Section II.B., NRSRO noaction letters have been provided to
67 Id.
68 See, e.g., Letter from Jonathan C. Conley,
Federated Investment Management Company, to
Jonathan G. Katz, Secretary, Commission (July 28,
2003).
E:\TEMP\25APP3.SGM
25APP3
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
such firms in the past. In these
instances, even though the credit rating
agencies were generally accepted in the
financial markets for a limited sector of
the debt market or a limited geographic
area, their market acceptance was based
on the credibility and reliably of their
ratings. Accordingly, the regulatory use
of those ratings in Commission rules
and regulations was appropriate and
consistent with the purposes underlying
the NRSRO concept.
Questions: Should a credit rating
agency that is recognized by the
financial marketplace for issuing
credible and reliable ratings within a
limited sector or geographic area meet
the NRSRO definition only for its
ratings within such sector or geographic
area, or more broadly? If a credit rating
agency meets the NRSRO definition
only with respect to its ratings within a
particular sector or geographic area,
would the NRSRO classification
interfere with the credit rating agency’s
ability to expand its business? How
should ratings from such an NRSRO be
identified so that broker-dealers and
other users of NRSRO ratings for
regulatory purposes can determine
which credit ratings from the NRSRO
may be used for regulatory purposes?
We noted above that commenters
mentioned that it would be difficult for
limited coverage NRSROs to provide a
full and accurate assessment of credit
risks without a broader expertise in
credit risk assessment. We request
further comment on this view given our
proposal to permit limited coverage
NRSROs.
rmajette on DSK29S0YB1PROD with PROPOSALS
3. The Third Component
The third proposed component of the
NRSRO definition is designed to ensure
that to meet the definition of the term
‘‘NRSRO,’’ a credit rating agency uses
systematic procedures designed to
ensure credible and reliable ratings,
manage conflicts of interest, and prevent
the misuse of nonpublic information. It
also addresses the need for credit rating
agencies to have sufficient financial
resources to ensure compliance with
such procedures, if they are to meet the
definition.
The Commission preliminarily
believes that including in the proposed
definition the requirement that an entity
use systematic rating procedures in
producing credit ratings should help to
ensure that NRSRO ratings are based on
a thorough credit analysis of issuers and
their financial obligations. This type of
analysis should, in turn, assist the credit
rating agency in producing credible and
reliable ratings, which as discussed
above, would further the purposes
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
underlying the regulatory uses of
NRSRO ratings.
The Commission preliminarily
believes that the following would be
important for assessing whether a credit
rating agency meets the third
component of the proposed definition:
(i) The experience and training of a
firm’s rating analysts (pertaining to the
analysts’ ability to understand and
analyze relevant information); (ii) the
average number of issues covered by
analysts (relevant to whether analysts
are capable of continuously monitoring
and assessing relevant developments
relating to their ratings); (iii) the
information sources reviewed and relied
upon by the credit rating agency and
how the integrity of information utilized
in the ratings process is verified
(relating to the extent and quality of
information upon which a firm’s ratings
are based); (iv) the extent of contacts
with the management of issuers,
including access to senior level
management and other appropriate
parties (pertaining to, among other
things, the quality and credibility of an
issuer’s management and to attempt to
better understand the issuer’s financial
and operational condition); (v) the
organizational structure of the credit
rating agency (to demonstrate, among
other things, the firm’s independence
from the companies it rates and from
potential conflicts of interest that may
result from related businesses or those
of an affiliate); (vi) how the credit rating
agency identifies and manages or
proscribes conflicts of interest affecting
its ratings business; (vii) how the credit
rating agency monitors and enforces
compliance with its procedures
designed to prohibit the misuse of
material, nonpublic information; and
(viii) the financial resources of the
credit rating agency (regarding whether,
among other things, a credit rating
agency has sufficient financial resources
to ensure that it maintains appropriate
staffing levels to continuously monitor
the issuers whose securities it rates and
to operate independently of economic
pressures or control from the companies
it rates and from subscribers).
a. Analyst Experience and Training
There was no consensus among
commenters to the 2003 Concept
Release as to whether the experience
and training of a credit rating agency’s
staff should be a factor in determining
whether a credit rating agency is an
NRSRO. Similarly, there was no
consensus as to whether the
Commission should include in an
NRSRO definition minimum standards
for the training and qualifications of the
credit rating agency’s credit analysts.
PO 00000
Frm 00009
Fmt 4701
Sfmt 4702
21313
Several commenters indicated that the
competency of a credit rating agency’s
staff should be a relevant consideration
in connection with being an NRSRO,
and that experience and training of a
credit rating agency’s staff are of
particular importance.69 Several
commenters suggested that, to be an
NRSRO, a credit rating agency should
develop minimum standards for training
and qualification of its analysts, and
that compliance with such standards
should be verified when assessing
whether a credit rating agency is an
NRSRO.70 There was also support
among commenters that an NRSRO
should take steps to verify whether
members of its staff have been subject to
disciplinary action by a financial (or
other) regulatory authority.71
While several commenters were of the
view that minimum training standards
for NRSROs would be appropriate, a few
indicated that oversight of training
methods would add little value to the
NRSRO concept.72 One commenter
recommended that NRSROs should be
required to disclose staff qualifications
and staff size on a periodic basis.73
Several commenters also represented
that credit rating agencies with staffing
deemed inadequate by the marketplace
would quickly be rejected by investors
and issuers.74
The Commission is not proposing to
require that a credit rating agency satisfy
specified minimum experience and
training requirements to meet the
proposed definition of the term
‘‘NRSRO.’’ A credit rating agency with
an inadequately trained and
inexperienced staff would likely
encounter difficulties meeting the
second and third components of the
proposed definition. However, the
Commission currently believes that to
meet the proposed definition of the term
‘‘NRSRO,’’ a credit rating agency should
have procedures designed to ensure that
its analysts are competent—that is, that
they are able to identify, understand,
and analyze information relevant to the
issuers whose securities they rate. A
credit rating agency should also have
procedures designed to examine the
backgrounds of its analysts and other
members of its staff.
69 See, e.g., Letter from Mark Roemer, Finance
Strategies, Siemens AG, to Commission (July 28,
2003).
70 See, e.g., Letter from William M. Wells, Chief
Financial Officer, Bunge Limited, to Commission
(July 28, 2003).
71 See, e.g., Letter from Joseph E. Cantwell,
President, Cantwell & Company, to Commission
(July 22, 2003).
72 Id.
73 See, e.g., Letter from Cate Long, MultipleMarkets, to Commission (July 28, 2003).
74 See, e.g., supra note 61.
E:\TEMP\25APP3.SGM
25APP3
21314
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
The Commission believes that analyst
experience and training is an important
consideration with regard to the NRSRO
concept because credit ratings relied
upon by the marketplace typically result
from thorough and competent credit
analysis employed by a credit rating
agency’s analysts. For example, if a
credit rating agency’s rating procedures
require an analyst to evaluate an issuer’s
financial statements, the ability of the
analyst to understand and analyze those
financial statements depends on the
analyst’s experience and training in
financial analysis. If the credit rating
agency’s rating procedures do not
require such experience and training, it
follows that the credit rating agency
would not have systematic procedures
designed to ensure credible and reliable
ratings, and that it would be
inappropriate to rely on the credit rating
agency’s ratings for providing limited
exemptions or privileges in Commission
rules.
While the Commission is not
proposing to require NRSROs to
disclose staff qualifications and size on
a periodic basis, as suggested by
commenters, such disclosures on a
voluntary basis could assist users of a
credit rating agency’s ratings in
assessing whether the credit rating
agency uses systematic procedures
designed to ensure credible and reliable
ratings.
Questions: The Commission
recognizes that the evaluation of an
analyst’s experience would involve a
degree of subjectivity. The Commission
requests comment on the appropriate
subjective criteria that a credit rating
agency should use in assessing the
experience and training of an analyst to
meet the proposed NRSRO definition. In
addition, what objective criteria are
relevant? What level of importance
should be given to the subjective and
objective criteria? How can a credit
rating agency in seeking to meet the
proposed NRSRO definition
demonstrate that it has adequate
procedures designed to ensure that its
analysts are competent? What factors
should a credit rating agency consider
in evaluating the background of its
analysts and other members of its staff?
rmajette on DSK29S0YB1PROD with PROPOSALS
b. Number of Ratings Per Analyst
While there was little support for the
Commission to condition NRSRO status
on an entity’s meeting standards for a
maximum average number of issues
covered per analyst, there was support
for requiring NRSROs to disclose the
number of credit analysts they employ
and the average number of issues rated
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
or otherwise followed by those
analysts.75
Commenters generally shared the
view that the number of analysts and
number of issues rated per analyst are
best left to the credit rating agencies.76
They also generally agreed that strong
incentives exist for credit rating
agencies to monitor the quality of their
analysis due to the constant scrutiny
from both issuers and investors.77
Further, they agreed that analysts must
maintain reasonable workloads for their
analytical quality to remain high.78
Concern was also expressed that setting
such standards would involve the
Commission too deeply into the
business practices of credit rating
agencies and that they could potentially
create barriers to NRSRO status.79
Based on the views of commenters,
the Commission is not proposing that a
credit rating agency must have specific
limits on the number of securities rated
per analyst to meet the definition of the
term ‘‘NRSRO.’’ However, as a
preliminary matter, the Commission is
concerned that a credit rating agency’s
ratings may become less reliable as the
number of issues rated per analyst
increases. This appears more significant
to the extent an analyst rates securities
of issuers with complex business
models operating in a variety of
industries.
Due to this concern, and the
Commission’s preliminary belief that
credit ratings used for regulatory
purposes should be the result of a
competent and thorough analysis, a
credit rating agency should be able to
demonstrate to users of its securities
ratings that its analysts are capable of
continuously monitoring and assessing
relevant developments relating to their
ratings. Thus, the number of ratings per
analyst could be an important
consideration for users of securities
ratings in assessing under the third
component of the proposed definition
whether a credit rating agency uses
systematic procedures designed to
ensure credible and reliable ratings.
While the Commission is not
proposing to require credit rating
agencies to disclose the number of
credit analysts they employ and the
average number of issues rated or
otherwise followed by those analysts, as
suggested by commenters, it may be that
disclosures such as these would assist
users of a credit rating agency’s ratings
in assessing whether the credit rating
75 See,
76 See,
e.g., supra note 73.
e.g., supra note 70.
77 Id.
78 See,
e.g., supra note 71.
79 See, e.g., supra note 40.
PO 00000
Frm 00010
Fmt 4701
Sfmt 4702
agency uses systematic procedures
designed to ensure credible and reliable
ratings.
Questions: Is the concern that a credit
rating agency’s ratings may become less
reliable as the number of issues rated
per analyst increase valid? If so, what
type of workload is reasonable for the
analytical quality of a credit rating
agency’s ratings to remain high? Should
the Commission specify minimum
standards for a credit rating agency’s
analysts to continuously monitor and
assess relevant developments relating to
their ratings so that users of the credit
rating agency’s ratings can determine
whether the credit rating agency meets
the NRSRO definition? If a credit rating
agency relies primarily on quantitative
models to develop credit ratings, how
can such a firm’s ratings reflect a
thorough analysis of the specific credit
characteristics of a particular security?
Should the Commission require credit
rating agencies to disclose the number
of credit analysts they employ and the
average number of issues rated or
otherwise followed by those analysts, as
suggested by commenters?
c. Information Sources Used in the
Ratings Process
The process of rating a particular
issuer’s securities typically begins with
collecting relevant financial information
about the issuer. Relevant financial
information often includes an issuer’s
recent past financial performance and
current financial condition. This
information generally is obtained
directly from the issuer in the form of
audited and unaudited financial
statements. In some instances, credit
rating agencies rely on third parties that
collect the information and disseminate
it through proprietary data feeds.
Generally, these vendors download or
otherwise obtain public financial
information (e.g., from 10–K’s and 10–
Q’s) and repackage such information
into data feeds to subscribers.
The reliability of a credit rating
agency’s ratings depends, in part, on the
integrity of the information upon which
the credit rating agency bases its ratings.
Therefore, the Commission believes
that, to meet the third component of the
NRSRO definition, credit rating agencies
should have controls in place to
reasonably assess the integrity of the
information sources they rely on in their
ratings process.80 For example, if a
credit rating agency is relying on
quantitative financial results, such as an
issuer’s quarterly earnings, provided by
80 We do not intend here to suggest that a credit
rating agency must audit or otherwise ensure the
accuracy of an issuer’s financial condition.
E:\TEMP\25APP3.SGM
25APP3
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
a third-party vendor, the credit rating
agency should have a process designed
to test the integrity of the vendor’s
information. This could include crosschecking a sample of the earnings
reports against other sources such as
audit reports, Commission filings (e.g., a
10–K or 10–Q), or by contacting the
issuer.
Questions: Should a credit rating
agency be required to test in some way
the integrity of information provided
directly by issuers (both public and
nonpublic) and through third party
vendors? Are there other appropriate
objective methods for determining
whether a credit rating agency has
reasonably tested the integrity of the
information on which it bases its
ratings?
rmajette on DSK29S0YB1PROD with PROPOSALS
d. Contacts With Management
In the 2003 Concept Release, the
Commission inquired whether it should
limit the credit ratings that can be used
for regulatory purposes in Commission
rules to credit rating agencies that
regularly contact senior management of
an issuer. A number of commenters
indicated that obtaining senior
management’s views enhances a credit
rating agency’s ability to assess the
quality and credibility of an issuer’s
management and to attempt to better
understand the issuer’s operational and
financial condition.81 Others, however,
indicated that it is possible to perform
a high quality credit analysis when
sufficient publicly available information
exists on an issuer.82 It was noted by
commenters that requiring contact with
issuer management could act as a barrier
to entry for smaller credit rating
agencies that cannot compel issuers to
engage in a dialogue.83 Other
commenters indicated that issuer
management would be less inclined to
talk to credit rating agencies issuing
lower ratings.84
The Commission’s proposed
definition of the term ‘‘NRSRO’’ does
not explicitly limit the definition of the
term ‘‘NRSRO’’ to entities that
systematically contact an issuer’s senior
management. Nonetheless, it could be
important for a credit rating agency
whose credit ratings will be used for
regulatory purposes to involve in the
rating process, when possible, an
issuer’s senior management, or, in the
81 See,
e.g., supra note 69.
e.g., supra note 40.
83 See, e.g., Letter from LACE Financial Corp.
(July 25, 2003).
84 See, e.g., Letter from Sean J. Egan, Managing
Director, Egan-Joens Ratings Co., to Jonathan G.
Katz, Secretary, SEC (July 28, 2003).
82 See,
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
case of issuers of asset-backed
securities, other appropriate parties.85
Question: In designing and
implementing systematic procedures to
ensure credible and reliable ratings,
should a credit rating agency seeking to
meet the definition of NRSRO address
how and the extent to which it involves
an issuer’s senior management in the
rating process? To meet the proposed
NRSRO definition, should a credit
rating agency’s procedures require that
the credit rating agency request an
issuer’s senior management to
participate in the credit rating agency’s
rating process without incurring a fee?
e. Organizational Structure
Commenters generally agreed that
organizational structure is an
appropriate factor to consider when
evaluating whether a rating agency is an
NRSRO. Commenters indicated that
credit rating agencies typically structure
their businesses to ensure that their
ratings have been thoroughly analyzed,
reviewed, and approved by independent
and relevant persons within a credit
rating agency’s organization, and that
because of this, it would be appropriate
to consider a credit rating agency’s
organizational structure when
evaluating a credit rating agency’s status
as an NRSRO.86 Several commenters
also believed that this would enable the
Commission to better identify and
potentially minimize conflicts of
interest issues at NRSROs.87
Some commenters believed that
NRSROs should consent to limiting
their business to issuing credit ratings
because it would be useful to prevent
NRSROs from engaging in activities that
raise conflicts of interest issues.88
Others disagreed, however, indicating
that it is not necessary or in investors’
best interests to preclude an NRSRO
from being part of a larger business
organization that has the ability to offer
financial strength and stability and can
support the level of investment
necessary to continually enhance their
ratings operations.89
For the reasons discussed above, the
Commission preliminarily believes that
a credit rating agency’s organizational
structure would be relevant to
determine whether the credit rating
85 For instance, we would expect ratings on
securities issued by asset-backed issuers to involve,
as appropriate, the senior personnel of their
depositor and servicer.
86 See, e.g., supra note 41.
87 See, e.g., Letter from Olivier Raingeard, to
Commission (July 27, 2003).
88 See, e.g., Letter from Takashi Kanasaki,
Managing Director, Japan Credit Rating Agency,
Ltd., to Jonathan G. Katz, Secretary, Commission
(July 14, 2003).
89 See, e.g., supra note 40.
PO 00000
Frm 00011
Fmt 4701
Sfmt 4702
21315
agency meets the definition of NRSRO.
For example, such structure should
include a process for ensuring that
credit ratings are analyzed, reviewed,
and approved at all appropriate levels
within the credit rating agency’s
organizational structure. Further, the
organizational structure of a credit
rating agency can also be designed to
avoid or minimize potential conflicts of
interest and prevent the misuse of
nonpublic information (e.g., through
firewalls separating ratings services and
analysts from affiliated businesses).
Though the Commission is not
defining the term ‘‘NRSRO’’ to exclude
a credit rating agency from being part of
a larger business organization, certain
affiliated businesses of a credit rating
agency could interfere with the credit
rating agency’s ability to meet the
proposed NRSRO definition. For
example, a credit rating agency that is
affiliated with an entity that
underwrites securities rated by the
credit rating agency would have a
difficult time meeting the third
component regarding procedures to
manage conflicts of interest.
Questions: Would information on a
credit rating agency’s organizational
structure be useful to users of ratings?
If so, what information would be useful?
f. Conflicts of Interest
Conflicts of interest may arise in a
number of areas within a credit rating
agency. For example, commenters to the
2003 Concept Release indicated that
reliance on issuer fees by a credit rating
agency could lead to conflicts of interest
and the potential for rating inflation.90
Commenters also represented that
conflicts of interest can arise when
credit rating agencies offer consulting or
other advisory services to the entities
they rate.91 In addition, during the
Commission’s 2002 credit rating agency
hearings, hearing participants indicated
that a credit rating agency’s subscribers
could be given preferential access to
rating analysts and, as a result,
inappropriately may learn of potential
rating actions or other nonpublic
information. The Commission notes that
conflicts may arise as well when a
person associated with a credit rating
agency (e.g., an employee) also is
associated with or has an interest in an
issuer that is being rated.
As noted above, investors rely on
credit ratings directly and through
investor protection regulation that uses
the NRSRO concept. Given this reliance,
an investor could be harmed if a rating
is unduly influenced by a person with
90 See,
e.g., supra note 84.
91 Id.
E:\TEMP\25APP3.SGM
25APP3
21316
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
rmajette on DSK29S0YB1PROD with PROPOSALS
a vested interest in the level of the
rating.
In responding to the 2003 Concept
Release, most commenters supported
the idea of conditioning NRSRO status
on a credit rating agency implementing
procedures to address conflicts of
interest in its business.92 We believe
that concerns about conflicts of interest
are valid and have therefore proposed,
as part of the definition of the term
‘‘NRSRO,’’ that an entity must use
systematic procedures designed to
manage potential conflicts of interest.
To satisfy this part of the definition, a
credit rating agency should, at a
minimum, be able to identify the types
of conflicts of interest that arise in its
business, its procedures designed to
address and minimize or avoid those
conflicts of interest, and how the firm
monitors and verifies compliance with
those procedures. The Commission
believes that it is necessary for an
NRSRO to take these steps to address
conflicts of interest because credit
ratings may be unduly influenced by
obligors, subscribers, or other interested
persons if conflicts of interest are not
handled appropriately.
Further, if a credit rating agency has
adopted procedures to address conflicts
arising, for example, between its ratings
business and its affiliated advisory
business, then such procedures, if
followed, would reduce the risk that
obligors will be unduly pressured into
purchasing advisory services in order to
maintain their credit rating.93
Questions: What specific conflicts of
interest should be addressed in a credit
rating agency’s procedures and how
should they be addressed? Should a
credit rating agency that engages in
activities that present potential or actual
conflicts of interest be excluded from
the definition of NRSRO? Alternatively,
is it sufficient for a credit rating agency
92 See, e.g., Letter from Charles D. Brown, General
Counsel, Fitch Ratings, to Jonathan G. Katz,
Secretary, SEC (July 28, 2003).
93 A separate area of concern arises when credit
rating agencies issue unsolicited ratings. These are
ratings that are not initiated at the request of the
issuer. Specifically, one concern with unsolicited
ratings is that they will be used by a credit rating
agency to obtain business from issuers. For
example, a credit rating agency could conceivably
issue an unsolicited rating and send it to the issuer
along with a fee schedule for its rating services. See,
e.g., Letter from James I. Kaplan, Associate General
Counsel, Northern Trust Corporation, to Jonathan G.
Katz, Secretary, Commission (July 28, 2003).
Moreover, the rating agency improperly might issue
a lower than warranted rating in order to increase
the issuer’s incentive to purchase the rating service.
We believe that unsolicited ratings raise sufficient
concerns such that a credit rating agency should
have procedures designed to avoid employing
improper practices with respect to unsolicited
ratings and to monitor and verify compliance with
those procedures.
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
to impose and implement safeguards to
prevent potential conflicts of interest
from affecting the quality and
independence of its credit ratings? Are
there other practices that raise concerns
similar to those raised by conflicts of
interest, for example, those referred to
in footnote 93 regarding unsolicited
ratings, that should be addressed in a
credit rating agency’s procedures?
g. Misuse of Information
Some credit rating agencies, as part of
their analysis, maintain contact with
senior management of the issuers they
rate. In the course of these contacts, an
issuer may provide an analyst with
nonpublic information such as
contemplated business transactions or
estimated financial information. There
is a potential that this information could
be used by a credit rating analyst or
others for improper purposes. In fact,
the Commission recently brought an
insider trading action against a former
analyst of a credit rating agency.94 The
Commission, in that case, alleged that
the analyst obtained information about
two proposed transactions and tipped
that information to others.95
As this example shows, there is the
risk that persons exposed to such
material, nonpublic information may
trade on it. In fact, the Commission staff,
as part of its 2002 NRSRO examinations
discussed above in Section II, identified
as a potential concern, among other
things, the effectiveness of the NRSROs’
existing policies and procedures
designed to protect confidential
information.96 In light of this concern,
the Commission posed a number of
questions in the 2003 Concept Release
to solicit comment on the protection of
nonpublic information. For example,
the Commission asked whether NRSRO
recognition should be conditioned on a
credit rating agency having internal
procedures to prevent the misuse of
nonpublic information.97 Commenters
generally acknowledged the importance
of protecting nonpublic information
provided by issuers.98 They explained
that nonpublic information greatly
assists credit rating agencies in issuing
credible and reliable ratings and pointed
out that if credit rating agencies had a
track record of failing to protect such
94 Commission v. Rick A. Marano, William
Marano and Carl Loizzi, Civil Action No. 04 CV
5828 (Judge Kimba Wood) (S.D.N.Y. July 27, 2004),
available on the SEC Web site at https://
www.sec.gov/litigation/litreleases/lr18799.htm.
95 Id.
96 See supra note 28.
97 See supra note 1.
98 See, e.g., supra note 59.
PO 00000
Frm 00012
Fmt 4701
Sfmt 4702
information, issuers would stop
providing such information.99
The Commission believes that for a
credit rating agency to meet the
proposed definition of the term
‘‘NRSRO,’’ it should have policies and
procedures that are designed to
effectively protect nonpublic
information provided by issuers.
Accordingly, under the third component
of the proposed NRSRO definition, a
credit rating agency would be required
to adopt and implement procedures
designed to prohibit the misuse of
material, nonpublic information
obtained during the credit rating
process. The Commission believes that
to meet this component of the NRSRO
definition, a credit rating agency should
adopt procedures governing the receipt
and use of nonpublic information that
applies to all employees.
Question: As discussed above, to meet
the third component of the NRSRO
definition, should a credit rating agency
demonstrate that it has systematic
procedures designed to prevent the
misuse of material nonpublic
information? What types of procedures
are reasonable for a credit rating agency
to protect material nonpublic
information? Should a credit rating
agency have personnel dedicated
specifically to verifying employees’
compliance with such procedures?
Should persons performing this
function provide ongoing training of
employees and act as a resource to
answer questions as they arise? Should
the procedures provide for a system by
which employees can report violations
of the controls in place to protect
nonpublic information or other
inappropriate activities? The
Commission encourages commenters to
provide information on appropriate
procedures for receiving and adequately
securing material nonpublic
information.
h. Financial Resources
There was no consensus among
commenters to the 2003 Concept
Release as to whether a credit rating
agency’s financial resources should be
considered by the Commission as a
condition for NRSRO recognition.
Several commenters supported the
evaluation of a credit rating agency’s
financial resources as a condition,
particularly to ensure that NRSROs
maintain financial independence from
rated issuers and subscribers.100 One
commenter suggested that such a
99 See,
e.g., supra note 40.
e.g., Letter from Walter Schroeder,
President, Dominion Bond Rating Service Limited,
to Jonathan G. Katz, Secretary, Commission (August
5, 2003).
100 See,
E:\TEMP\25APP3.SGM
25APP3
rmajette on DSK29S0YB1PROD with PROPOSALS
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
condition be used to ensure that an
NRSRO does not receive more than a
small portion of revenue from any
particular issuer or customer,101 and
another suggested that NRSROs be
required to disclose information relating
to their financial resources.102 One
commenter also stated that it would be
prejudicial to investors if securities they
purchased, based in part on credit
ratings, ceased to be rated because the
credit rating agencies that rated them no
longer existed.103
Commenters that opposed the use of
financial resources as an NRSRO
criterion generally represented that
meeting a mandated level of capital or
financial resources does not assure the
credibility or reliability of a credit rating
agency’s ratings and, accordingly, the
Commission should instead focus on
such credibility and reliability.104
The Commission is not proposing to
specify minimum financial
requirements as part of the definition of
the term ‘‘NRSRO.’’ The Commission
anticipates that the financial resources
necessary to support an NRSRO would
vary based on the size and scope of the
credit rating agency’s business. The
Commission has proposed, however,
that in order for a credit rating agency
to meet the definition of the term
‘‘NRSRO,’’ it would be required to have
sufficient financial resources to ensure
that it is able to comply with its
procedures. For example, to meet the
definition, a credit rating agency would
need to have sufficient financial
resources to ensure that it maintains
appropriate staffing levels to
continuously monitor the issuers it
rates. Further, a credit rating agency
with sufficient financial resources is
less likely to be subject to conflicts of
interest as described above because of
its financial independence from
subscribers and issuers it rates.
Questions: Should a credit rating
agency make its audited financial
statements readily available to users of
securities ratings in order for such users
to assess whether a credit rating agency
has sufficient financial resources to
satisfy the third component? What other
types of financial information could a
credit rating agency make available to
users of securities ratings for purposes
of the third component? Should a credit
rating agency provide users of securities
ratings with information relating to the
percentage of revenue it receives from
particular issuers or subscribers as
compared to the credit rating agency’s
e.g., supra note 63.
e.g., supra note 73.
103 See, e.g., supra note 70.
104 See, e.g., supra note 87.
total revenues? Should a credit rating
agency establish procedures to limit the
percentage of revenues it receives from
a single issuer or subscriber? How else
can it be determined that a credit rating
agency is financially independent of
both subscribers and rated issuers?
Questions: Should the Commission
continue to rely on existing marketbased standards for rating symbols and
rating categories, or should specific
standards be incorporated into the
definition of the term ‘‘NRSRO’’? If the
latter, what standards are appropriate?
i. Standardized Rating Symbols
C. Statistical Models
In the 2003 Concept Release, the
Commission inquired whether credit
rating agencies that solely use statistical
models and no other qualitative inputs
should be able to qualify as NRSROs.
There was a general consensus among
commenters that computerized
statistical models may be helpful in the
credit rating process, but that a credit
rating agency that solely uses statistical
models should not qualify as an
NRSRO.108 Most commenters
responding to this question identified
limitations with regard to the use of
such models for providing in-depth
credit analysis.109 One commenter
stated that the Commission staff does
not have the expertise to evaluate the
types of models used by most credit
rating agencies.110
However, one commenter noted that
purely quantitative credit models have
gained acceptance by credit risk
managers in recent years, and that such
models should be further considered
before restricting NRSRO status to
companies who do not solely rely on
statistical models.111
Although commenters were generally
of the view that credit rating agencies
that rely solely on statistical models
should not qualify as NRSROs, the
Commission, in proposing to define the
term ‘‘NRSRO,’’ is not precluding
through this proposed definition the
possibility that a credit rating agency
with a more quantitative business model
than the current NRSROs could meet
the definition of NRSRO. Accordingly,
the proposed definition of the term
‘‘NRSRO’’ and the interpretations to the
definition contained in this release
should not be construed as excluding a
credit rating agency that significantly
relies on quantitative statistical models
in developing credit ratings.
Questions: Should a credit rating
agency that relies solely or primarily on
statistical models be able to meet the
proposed NRSRO definition? If so,
under what circumstances? The
Commission also requests comment on
guidelines for assessing the relevance
and reliability of statistical models used
in the ratings process.
Several commenters responded to the
Commission’s request on whether
NRSROs should use uniform rating
symbols to reduce the risk of
marketplace confusion. Commenters
generally supported the idea of uniform
rating symbols by NRSROs, indicating
that such standardization would be
particularly helpful if the number of
NRSROs increase.105 However, one
credit rating agency indicated that
mandated uniformity of rating symbols
could mislead investors into assuming
that all NRSRO credit ratings are
comparable and involve the same
analytical judgments, ratings criteria,
and methodologies.106 Another
commenter suggested that rather than
establish uniform rating symbols, the
Commission should require each
NRSRO to annually disclose the
definition and historic default rates for
the rating symbols it uses.107
The Commission is not proposing to
standardize the use of rating symbols by
NRSROs. While the symbols used by an
NRSRO to distinguish securities of
varying risks may technically differ both
in form and in meaning from those used
by other NRSROs (e.g., S&P’s lowest
investment grade rating category for
corporate debt securities is ‘‘BBB’’ and
Moody’s is ‘‘Baa’’), the similarities in
NRSROs’’ rating symbols (including the
symbols previously used by entities that
received NRSRO no-action letters but no
longer exist) suggests the existence of a
market-based standard.
Similarly, there appears to be an
existing market-based standard for
credit rating agencies to have a
consistent number of rating categories
for distinguishing securities of varying
risks. This latter standard is important
for purposes of the NRSRO concept
because a number of Commission rules
referencing the term ‘‘NRSRO’’ also
reference the NRSRO’s levels of rating
categories. For example, paragraph
(c)(2)(vi)(F) of the net capital rule sets
forth regulatory capital charges for
proprietary positions of broker-dealers
in nonconvertible debt securities rated
in ‘‘one of the four highest rating
categories’’ by at least two NRSROs.
101 See,
108 See,
102 See,
VerDate Nov<24>2008
15:07 Oct 19, 2009
105 See,
e.g., supra note 73.
106 See, e.g., supra note 40.
107 See, e.g., supra note 61.
Jkt 220001
21317
PO 00000
Frm 00013
Fmt 4701
Sfmt 4702
e.g., supra notes 59, 73, and 92.
e.g., supra note 88.
110 See, e.g., supra note 84.
111 See, e.g., supra note 41.
109 See,
E:\TEMP\25APP3.SGM
25APP3
rmajette on DSK29S0YB1PROD with PROPOSALS
21318
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
D. Provisional NRSRO Status
In the past, a number of observers
have criticized the regulatory use of the
NRSRO concept—particularly the
‘‘national recognition’’ requirement—as
creating a substantial barrier to entry. In
essence, these critics contend that
important users of securities ratings
have a regulatory incentive to obtain
ratings issued by NRSROs, and that
without NRSRO status new entrants
encounter great difficulties achieving
the ‘‘national recognition’’ necessary to
obtain an NRSRO no-action letter.
For example, the U.S. Department of
Justice (‘‘DOJ’’), commenting on the
Commission’s 1997 rule proposal,
opposed the use of the ‘‘national
recognition’’ requirement because, in its
view, that criterion likely creates a
‘‘nearly insurmountable barrier to new
entry into the market for NRSRO
services.’’ 112 DOJ believed that, while
the historical dominance of Moody’s
and S&P had eroded in recent years for
certain types of securities ratings, the
overall level of market power they
retained continued to be a competitive
concern. To ameliorate entry barriers,
DOJ suggested the Commission consider
giving ‘‘provisional’’ NRSRO status (for
the first 12 to 18 months of existence)
to newly-formed credit rating affiliates
of established, well-capitalized firms
that have reputations for quality
financial analysis in the investment
community (e.g., investment banks,
commercial banks, insurance
companies, consulting firms, or
accounting firms). DOJ also
recommended the Commission consider
‘‘provisional’’ NRSRO status for foreign
rating agencies, and indicated they
might initially specialize in rating U.S.
companies with substantial operations
abroad.
In response to these concerns, the
Commission, in the 2003 Concept
Release, sought comment on whether to
consider a ‘‘provisional’’ NRSRO status
for credit rating agencies that comply
with NRSRO recognition criteria but
lack national recognition. Most
commenters generally did not support
the concept of ‘‘provisional’’ NRSROs.
Commenters supporting provisional
NRSROs indicated that permitting them
could promote competition among
credit rating agencies by facilitating the
entry of high-quality but lesser-known
credit rating agencies.113 One
commenter stated that credit rating
112 See 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 (March 6,
1998).
113 See, e.g., supra note 87.
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
agencies that provide quality ratings but
are not national in nature could be
provisional NRSROs,114 while another
commenter represented that it would
support a time-limited provisional
NRSRO status if the Commission retains
the ‘‘widely accepted’’ criterion.115
Commenters opposing the idea of
provisional NRSROs represented that
permitting two classes of NRSROs
would likely cause marketplace
confusion,116 and that permitting
provisional NRSROs would have little,
if any, effect on a credit rating agency’s
ability to compete with the larger
NRSROs.117 Several commenters also
indicated that certain investors likely
would not use ratings from
‘‘provisional’’ NRSROs for regulatory
purposes because securities purchased
based on a provisional NRSRO’s ratings
would possibly have to be sold if the
provisional NRSRO failed to continue to
meet the definition.118
The Commission has considered the
responses to the 2003 Concept Release
and has decided at present against
creating a ‘‘provisional’’ NRSRO status.
The Commission’s use of the term
‘‘NRSRO’’ is intended to reflect the fact
that the marketplace views a credit
rating agency’s ratings as credible and
reliable. Without such assurance as to
the quality of the ratings issued by a
credit rating agency, it may be
inappropriate to rely upon a credit
rating agency’s ratings as a proxy for
credit quality in regulation.
The Commission understands that the
rationale for permitting provisional
NRSROs is to promote competition in
the credit rating industry. To this end,
defining the term ‘‘NRSRO’’ to include
credit rating agencies that confine their
activities to limited sectors of the debt
market or to limited (or largely nonU.S.) geographic areas may be a more
reasonable approach that attempts to
address the concerns raised by
commenters and preserve the
Commission’s intended regulatory
objectives. The Commission also notes
with respect to the competitive concerns
raised by commenters that since the
term ‘‘NRSRO’’ was first used in the
mid-1970’s, several credit rating
agencies have been able to enter the
credit rating business and achieve the
requisite level of market acceptance to
receive NRSRO no-action letters.
Question: Does the Commission’s
proposed NRSRO definition and
approach for promoting competition
114 See,
e.g., supra note 41.
e.g., supra note 63.
116 See, e.g., supra note 100.
117 See, e.g., supra note 61.
118 Id.
115 See,
PO 00000
Frm 00014
Fmt 4701
Sfmt 4702
address the competitive concerns raised
by commenters’ supporting provisional
NRSROs?
E. Staff No-Action Process
In the 2003 Concept Release, the
Commission asked a series of
procedural questions regarding the
NRSRO concept. Across the board,
commenters strongly supported
Commission action to enhance the
clarity of the process. However, a
number of commenters also raised
concerns about the extent of the
Commission’s legal authority to regulate
or impose requirements on NRSROs.119
In the absence of Congressional action,
we are proposing to adopt a
comprehensive definition of the term
‘‘NRSRO,’’ which we believe to be an
appropriate balance within the confines
of the Commission’s existing legal
authority.
As noted above, the Commission has
never adopted a definition of the term.
The Commission preliminarily believes
that the proposed components of the
NRSRO definition, discussed in detail
above, would be a significant step
forward in providing greater clarity in
determining whether an entity’s ratings
should be relied on as NRSRO ratings
for purposes of the securities laws, and
Commission rules and regulations. An
entity that meets the proposed
definition would be an NRSRO.
While we believe that adopting a
definition of NRSRO could help address
commenters’ concerns regarding
transparency, we understand that credit
rating agencies might desire to continue
to seek staff no-action letters in order to
provide some measure of certainty to
those entities relying on ratings
provided by credit rating agencies. As
such, and in light of the long-standing
reliance by broker-dealers, issuers,
investors and others on the existing staff
no-action process, if we were to adopt
a definition of NRSRO, we plan to
continue to make our staff available to
provide no-action letters as appropriate
to those entities that choose to seek it.
The continued provision of staff noaction letters, where appropriate, is
intended to provide more certainty.
Currently, a credit rating agency
initiates the no-action letter process by
requesting a no-action letter that will
state that the Commission staff will not
recommend enforcement action against
persons who use the firm’s credit ratings
for purposes of the Commission’s net
capital rule. Upon receipt of such a
request, the Commission staff typically
sends a letter to the credit rating agency
requesting detailed information
119 See,
E:\TEMP\25APP3.SGM
e.g., supra note 40.
25APP3
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
rmajette on DSK29S0YB1PROD with PROPOSALS
regarding the criteria discussed above.
After receiving this detailed
information, the Commission staff meet
with the credit rating agency for an onsite meeting. During this meeting, the
credit rating agency’s senior
management, analysts, and other
persons who are knowledgeable about
the firm’s policies and procedures are
interviewed. The Commission staff also
contacts and interviews references
provided by the credit rating agency and
others to assess, among other things, the
references’ use of the credit rating
agency’s ratings, whether they believe
the credit rating agency issues credible
and reliable ratings, and how the credit
rating agency compares to other credit
rating agencies.120 The Commission staff
then determines whether the credit
rating agency meets the NRSRO criteria
and either issues the requested noaction letter, or informs the credit rating
agency of its decision not to so issue a
letter.121
There was strong support in response
to the 2003 Concept Release for the
Commission to establish a time period
to serve as a goal for acting on requests
for NRSRO status.122 Some commenters
addressing this issue thought that the
process for seeking NRSRO status
should include deadlines once a credit
rating agency has submitted all required
information, and that such a time period
could enhance the market’s perception
of the NRSRO process and afford greater
certainty to a credit rating agency as to
when a ruling will be made on its
request.123
Some commenters believed that the
Commission should act on a request for
a no-action letter within 90 to 120 days
after an entity has submitted all
required information.124 Some
commenters noted, however, that
flexibility should exist if circumstances
arise and an additional investigation
needs to be conducted.125 Several
commenters stated that credit rating
agencies that do not obtain no-action
letters should be notified as to why so
120 These interviews have been useful indicators
of a credit rating agency’s marketplace recognition,
and the Commission anticipates that, in connection
with the no-action process, the staff will continue
to interview references and other predominant
users of securities ratings in determining which
credit rating agencies should receive a no-action
letter.
121 When issuing an NRSRO no-action letter, the
Commission staff has consistently conditioned such
letters on credit rating agencies not representing in
any of their ratings, marketing, or similar literature
that the Commission considers the credit rating
agency to be an NRSRO. See, e.g., supra note 2.
122 See, e.g., Letter from Andrew Fight to Jonathan
G. Katz, Secretary, Commission (July 25, 2003).
123 See, e.g., supra note 56.
124 See, e.g., supra note 46.
125 See, e.g., supra note 61.
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
that they can improve their operations
in the specified areas and increase their
chances of submitting a successful
request in the future.126
In this regard, we would expect that
no-action requests would be considered
by the staff, and resolved, in a timely
fashion.127 The Commission believes
that, if it were to adopt a definition of
the term ‘‘NRSRO,’’ the staff should be
able to act on NRSRO no-action requests
within 90 days after a credit rating
agency has submitted all necessary
information.128
Like any staff no-action position, the
staff’s views on whether an entity meets
the definition of NRSRO would be
conditioned on the facts and
representations made by the entity.129
Of course, if the facts and circumstances
upon which the staff relied to provide
its guidance change, the staff position
may no longer be applicable. In this
regard, given the changing market
conditions in this context, we
understand that the staff will include
expiration dates in NRSRO no-action
letters that it issues. In addition, the
staff’s views on issues may change from
time-to-time, in light of reexamination,
126 See,
e.g., supra note 100.
part of this process, the Commission staff
will inform the Commission promptly upon receipt
of a request for a no-action letter from a credit rating
agency.
128 The information provided to the staff by a
credit rating agency to obtain a no-action letter will
be accorded confidential treatment to the extent
permitted by law. However, it is the responsibility
of the credit rating agency to request confidentiality
under the appropriate Commission rules. See 17
CFR 200.83.
129 See generally 17 CFR 202.2. No-action
requests should be directed to an appropriate officer
of the Commission’s staff. Id. The no-action letter
process is an informal procedure that permits the
public to request the views of the Commission staff
on issues or activity that may raise compliance
issues under federal securities law. In a no-action
letter, the Commission staff states that it will not
recommend enforcement action to the Commission
with respect to identified rules or statutory
provisions if the requesting party acts in accordance
with specific facts and representations made in its
letter. In some instances, the Commission staff will
state that it is not able to give such assurance. The
Commission takes the position that no-action letters
do not constitute Commission precedent and do not
bind subsequent Commission action. Although
informal guidance from Commission staff assists the
public in understanding how to comply with the
Commission’s rules and policies, the Commission
reserves the right to act contrary to staff advice. See
Informal Guidance Program for Small Entities,
Release No. 33–7407 (March 27, 1997), 62 FR 15604
(April 4, 1997); and Procedures for Rendering
Informal Advice, Release No. 33–6253 (October 28,
1980), 45 FR 72644 (November 3, 1980). See also
17 CFR 202.1(d) (‘‘In certain instances an informal
statement of the views of the Commission may be
obtained. The staff, upon request or on its own
motion, will generally present questions to the
Commission which involve matters of substantial
importance and where the issues are novel or
highly complex, although the granting of a request
for an informal statement by the Commission is
entirely within its discretion.’’).
127 As
PO 00000
Frm 00015
Fmt 4701
Sfmt 4702
21319
new considerations, or changing
conditions that indicate that its earlier
views are not longer in keeping with the
objectives of the proposed NRSRO rule
or with the regulatory use of NRSRO
ratings.
IV. General Request for Comment
The Commission seeks comment
generally on all aspects of proposed
Exchange Act Rule 3b–10. In addition to
the specific requests for comment found
throughout this release, the Commission
invites general comments on the
proposed definition and the
interpretations. The Commission also
seeks comment on whether to expand
the text of the proposed rule to include
the interpretations of the components
discussed in this release, or other
interpretations. Furthermore, the
Commission invites interested persons
to submit written comments and data on
any aspects of the proposed rule.
V. Paperwork Reduction Act
Proposed Rule 3b–10 would not
impose a new ‘‘collection of
information’’ within the meaning of the
Paperwork Reduction Act of 1995.130
VI. Consideration of the Costs and
Benefits of the Proposed Rule
The Commission is sensitive to the
costs and benefits that result from its
rules. We have identified certain costs
and benefits of the proposed rule and
request comment on all aspects of this
cost-benefit analysis, including
identification and assessment of any
costs and benefits not discussed in the
analysis. The Commission requests data
to quantify the costs and the value of the
benefits identified. The Commission
seeks estimates and views regarding
these costs and benefits from market
participants who might be impacted by
the proposed rule, including credit
rating agencies, independent credit
analysts, broker-dealers, mutual fund
companies, securities issuers, and
investors.
A. Benefits
The proposed rule would define the
term ‘‘NRSRO’’ and thereby enhance the
use of the NRSRO concept in
Commission rules and regulations.
Specifically, it would provide greater
clarity to determine whether credit
rating agencies are NRSROs. This would
also assist credit rating agencies that are
currently NRSROs in understanding
how they can continue to meet the
definition. For credit rating agencies
that are not currently NRSROs, the
definition would provide a better
130 44
E:\TEMP\25APP3.SGM
U.S.C. 3501 et seq.
25APP3
rmajette on DSK29S0YB1PROD with PROPOSALS
21320
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
understanding of the enhancements
necessary to meet the definition. This
could reduce concerns related to
barriers to entry for credit rating
agencies seeking to become NRSROs.
Moreover, concerns about barriers to
entry also could be reduced by the
interpretations of the proposed
definition that would recognize credit
rating agencies with an expertise in a
particular industry or geographic region.
This component could be particularly
beneficial to smaller credit rating
agencies in their efforts to meet the
proposed definition of NRSRO.
By lowering the barriers to entry
identified above, the proposed rule
could potentially increase the number of
NRSROs. Issuers would be provided
with more choices in terms of selecting
NRSROs to rate their debt securities,
which could lower their costs for this
service. The greater competition in the
market for credit ratings and analysis
could provide for more credible and
reliable ratings. Greater competition also
could stimulate innovation in the
technology and methods of analysis for
issuing credit ratings, which could
further lower barriers to entry.
As previously noted, the NRSRO
concept was first used by the
Commission for the purposes of
determining capital charges for brokerdealers with respect to their proprietary
debt securities. Broker-dealers benefited
from this use of the NRSRO concept in
that it provided a simple regulatory
benchmark. At the same time, the
NRSRO concept benefited customers
and counterparties of broker-dealers by
linking the capital charge (and,
consequently, the broker-dealers’ capital
adequacy) to a rating that is recognized
by the marketplace as reliable and
credible. These benefits would continue
under the proposed rule.
The benefit of the NRSRO concept as
a regulatory benchmark and the
beneficial impact of the proposed
definition is indicated by its use in
various other Commission rules and
regulations; namely, Regulation S–B,131
Regulation S–K,132 Securities Act Rule
134 (‘‘Communications not deemed a
prospectus’’),133 Securities Act Rule 436
(‘‘Consents requires in special
cases’’),134 Form S–3,135 Form F–2,136
Form F–3,137 Exchange Act Rule 3a1–1
(‘‘Exemption from the definition of
‘‘Exchange’’ under the Section 3(a)(1) of
131 17
CFR 228.10.
CFR 229.10.
133 17 CFR 230.134.
134 17 CFR 230.436.
135 17 CFR 239.13.
136 17 CFR 239.32.
137 17 CFR 239.33.
132 17
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
the Act’’),138 Exchange Act Rule 10b–10
(‘‘Confirmation of transactions’’),139
Exchange Rule 15c3–1 (‘‘Net capital
requirements for brokers or dealers’’),140
Exchange Act Rule 15c3–1a
(‘‘Options’’),141 Exchange Act Rule
15c3–1f (‘‘Optional market and credit
risk requirements for OTC derivatives
dealers’’),142 Exchange Act Rule 15c3–
3a (‘‘Exhibit A—formula for
determination reserve requirement of
brokers and dealers under § 240.15c3–
3’’),143 Rule 101 of Regulation M under
the Exchange Act (‘‘Activities by
distribution participants’’),144 Rule 102
of Regulation M under the Exchange Act
(‘‘Activities by issuers and selling
security holders during a
distributions’’),145 Rule 300 of
Regulation ATS under the Exchange Act
(‘‘Definitions’’),146 Investment Company
Act Rule 2a–7 (‘‘Money market
funds’’),147 Investment Company Act
Rule 3a–7 (‘‘Issuers of asset-backed
securities’’),148 Investment Company
Act Rule 5b–3 (‘‘Acquisition of
repurchase agreement or refunded
security treated as acquisition of
underlying securities’’),149 and
Investment Company Act Rule 10f–3
(‘‘Exemption for the acquisition of
securities during the existence of an
underwriting or selling syndicate’’).150
The concept also has been used in
federal statutes, state laws, and foreign
laws and regulations.151 The
importation of a market assessment of
creditworthiness into a regulation
benefits the affected entities by linking
a regulatory requirement to a market
determined benchmark. Thus, the
proposed rule would result in the
benefits described above by codifying
the meaning of the term NRSRO.
B. Costs
The proposed rule would impose
some costs on existing NRSROs. They
could incur some costs in evaluating
themselves against the proposed
definition, and in seeking renewal of
their no-action letters, should the
Commission adopt a definition of
NRSRO. However, in this regard, we
note that the proposed definition of
138 17
CFR 240.3a1–1.
CFR 240.10b–10.
140 17 CFR 240.15c3–1.
141 17 CFR 240.15c3–1a.
142 17 CFR 240.15c3–1f.
143 17 CFR 240.15c3–3a.
144 17 CFR 242.101.
145 17 CFR 242.102.
146 17 CFR 242.300.
147 17 CFR 270.2a–7.
148 17 CFR 270.3a–7.
149 17 CFR 270.5b–3.
150 17 CFR 270.10f–3.
151 See, e.g., supra notes 14, 15, and 16.
139 17
PO 00000
Frm 00016
Fmt 4701
Sfmt 4702
‘‘NRSRO’’ is generally consistent with
the criteria historically used by the
Commission staff to identify NRSROs
for purposes of no-action relief under
the Commission’s net capital rule.
The proposed definition would not
impose direct costs on credit rating
agencies that do not currently meet the
proposed definition of ‘‘NRSRO,’’ since
these entities would not be within its
scope. A non-NRSRO credit rating
agency likely would incur costs if it
sought to become an NRSRO, or needed
to enhance its activities and operations
to meet the NRSRO definition. An entity
that is recognized nationally by the
predominant users of credit ratings as
issuing credible and reliable ratings
generally would meet the proposed
definition of ‘‘NRSRO’’ or would be able
to meet the definition with little
incremental cost. Accordingly, a credit
rating agency seeking to meet the
definition of ‘‘NRSRO’’ would not incur
costs beyond those that normally would
be expended to gain acceptance in the
marketplace, on a national level, as a
credit rating agency that is recognized as
issuing credible ratings. As such, the
Commission does not believe that the
proposed definition would increase
costs for a rating agency seeking to be
an NRSRO.
The Commission also notes that the
internet permits credit rating agencies to
publish their ratings to a worldwide
audience—i.e., make the ratings
publicly available—for a minimal cost.
Thus, a credit rating agency could meet
this component of the proposed
definition without incurring substantial
costs. Moreover, under the proposed
definition, a credit rating agency could
become an NRSRO if it is generally
accepted in the financial markets as an
issuer of credible and reliable ratings for
a particular industry or geographic
segment. This could make it easier for
a smaller entity, with a specific ratings
expertise, to become an NRSRO. As
such, over time, the proposed definition
could reduce costs by making it easier
for a credit rating agency that focuses on
a particular geographic area or sector to
be an NRSRO.
The Commission seeks comment on
the costs that would be incurred by a
non-NRSRO credit rating agency to meet
the proposed definition. As mentioned
above, to assist the Commission in
evaluating the costs and benefits that
may result from the proposed rule, the
Commission requests comment on the
potential costs and benefits identified in
the release, as well as any other costs or
benefits that may result from the
proposed rule. In particular, the
Commission requests comments on the
potential costs for any modification to
E:\TEMP\25APP3.SGM
25APP3
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
both computer systems and surveillance
mechanisms and for information
gathering, management, and
recordkeeping systems or procedures, as
well as any potential benefits resulting
from the proposals for registrants,
issuers, investors, brokers or dealers,
other securities industry professionals,
regulators, and others. The commenters
should provide analysis and data to
support their views on the costs and
benefits.
The Commission has found that
opinions differ regarding the critical
elements for success in the credit rating
business (e.g., staff, experience, capital),
and this may lead to varying views on
the precise nature and extent of the
costs and benefits. The Commission
poses the following questions regarding
the proposed rule: What are the costs for
an entity to operate as a credit rating
agency that is recognized on a national
level by the predominant users of credit
ratings as issuing credible and reliable
ratings? What are the costs for an entity
to enter into the credit rating business
with respect to rating securities within
a specific industry or geographic
segment? What additional costs would
such an entity incur to achieve national
recognition?
In answering these questions,
commenters should provide detailed
information on, or estimates of, the costs
associated with maintaining an office, a
staff, and the necessary communications
and information systems and equipment
as well as costs related to publishing
credit ratings. We also seek comment on
whether costs related to technology
have significantly increased in recent
years.
rmajette on DSK29S0YB1PROD with PROPOSALS
VII. Consideration on Burden and
Promotion of Efficiency, Competition,
and Capital Formation
Section 3(f) of the Exchange Act
requires the Commission, whenever it
engages in rulemaking and must
consider or determine if an action is
necessary or appropriate in the public
interest, to consider whether the action
would promote efficiency, competition,
and capital formation.152 In addition,
Section 23(a)(2) of the Exchange Act
requires the Commission, when making
rules under the Exchange Act, to
consider the impact that such rules
would have on competition.153
Exchange Act Section 23(a)(2) prohibits
the Commission from adopting any rule
that would impose a burden on
competition not necessary or
152 15
153 15
U.S.C. 78c(f).
U.S.C. 78w(a)(2).
VerDate Nov<24>2008
15:07 Oct 19, 2009
appropriate in furtherance of the
purposes of the Exchange Act.
The Commission preliminarily
believes that the proposed definition of
‘‘NRSRO’’ would not impose any
burdens on efficiency, capital formation
and competition and would, in fact,
promote these interests. The proposed
definition would provide greater clarity
to the process by which credit rating
agencies become NRSROs. This would
also assist credit rating agencies that are
currently NRSROs in understanding
how they could meet the proposed
definition. For credit rating agencies
that are not currently NRSROs, the
definition would provide a better
understanding of the enhancements
necessary to meet the proposed
definition. This could reduce concerns
regarding barriers to entry for credit
rating agencies seeking to become
NRSROs. Moreover, concerns about
barriers to entry also could be reduced
by the component of the proposed
definition that would recognize credit
rating agencies with an expertise in a
particular industry or geographic region.
This component could be particularly
beneficial to smaller credit rating
agencies in their efforts to meet the
proposed NRSRO definition.
By lowering any barriers to entry
discussed above, the proposed rule
could potentially increase the number of
NRSROs. Issuers could be provided
with more choices in terms of selecting
NRSROs to rate their debt securities,
which would lower their costs for this
service. The greater competition in the
market for credit ratings and analysis
could provide for more credible and
reliable ratings. Greater competition also
could stimulate innovation in the
technology and methods of analysis for
issuing credit ratings, which could
further lower barriers to entry.
The Commission believes the
resulting increased clarity from the
proposed definition could have some
positive impact on capital formation. As
noted in the Benefits Section in Section
VI., a number of Commission rules and
regulations use the NRSRO concept. For
example, certain regulations provide
safe harbors to small businesses issuing
securities and to all issuers in making
non-financial statements in securities
registrations.154 The NRSRO concept
also is used in defining which debt
securities can be held by a money
market fund.155 In addition, as noted
throughout, the NRSRO concept is used
in the broker-dealer capital rule. Finally,
states, foreign governments, and private
entities use the NRSRO concept as well.
154 See,
155 17
Jkt 220001
PO 00000
e.g., 17 CFR 228.10 and 17 CFR 229.10.
CFR 270.2a–7.
Frm 00017
Fmt 4701
Sfmt 4702
21321
The proposed definition, by codifying a
component of the NRSRO concept,
would provide clarity to its use in these
rules and regulations which all relate in
some respects to the issuance of debt
securities. Accordingly, the proposed
definition could assist in the
underwriting and making of markets in
corporate debt.
While we believe the proposed
definition could lower any barriers to
entry and promote competition, we
recognize that some market participants
have argued that the NRSRO concept
impedes competition by creating
unreasonable barriers to entry. There is
a widespread view that one of the most
significant natural barriers into the
credit rating business is the current
dominance of a few highly-regarded,
well-capitalized rating agencies that
pioneered the industry many decades
ago. This view may, in part, be a
consequence of the fact that, until the
mid-1970s, only a handful of firms
(primarily three of the five current
NRSROs) issued credit ratings on
securities. These firms developed
substantial brand names during the
period when they were the only entities
issuing securities ratings. Since the mid1970’s, however, there has been a steady
increase in the number of credit rating
agencies operating in the U.S. and
internationally, so that today it is
estimated that there are more than 100
active credit rating agencies
worldwide.156
It should be noted that this growth in
the number of entities issuing securities
ratings began after the Commission
started using the NRSRO concept for
regulatory purposes. The expansion
suggests a growing interest among
market participants for advice about
credit quality, and that new entrants are
able to develop a following for their
credit judgments. The Commission staff
also has provided no-action letters to
several small credit rating agencies
since it began using the NRSRO concept
for regulatory purposes.157 Several of
156 See Credit Ratings and Complementary
Sources of Credit Quality Information, Basel
Committee on Banking Supervision Working Papers
(August 2000), at 14 (‘‘[I]n September 1999, it was
believed that there might be some 130 [rating]
agencies world-wide, although industry sources
indicated this number was closer to 150.’’). See also
SEC Hearing Transcript, supra note 30, (November
21, 2003) (testimony of Gay Huey Evans, Director,
Markets and Exchanges Division, The Financial
Services Authority) (‘‘There are [approximately] 150
[rating] agencies in total around the world and they
vary in size and scope.’’).
157 Duff & Phelps, Inc. began issuing credit ratings
in 1974 and became an NRSRO in 1982. McCarthy
Crisanti & Maffei began issuing credit ratings in
1975 and became an NRSRO by 1983. IBCA Limited
and IBCA Inc. began issuing credit ratings in 1978
E:\TEMP\25APP3.SGM
Continued
25APP3
21322
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
these entities received no-action letters
within five or six years of the date they
began issuing securities ratings. The
Commission preliminarily believes this
may demonstrate that the proposed
‘‘NRSRO’’ definition could be met by
small firms and, accordingly, appears to
indicate that the proposed definition
would not act as an unreasonable barrier
to their meeting the definition of
NRSRO.
The Commission believes that, at this
time, eliminating the NRSRO concept
would not be prudent, nor in the
interest of investors and securities
market participants. For example, the
concept provides an easily ascertainable
and non-arbitrary regulatory benchmark
for broker-dealers to compute their
capital charges.158 At the same time, it
provides that broker-dealers will use
credit ratings that are recognized by the
marketplace as credible and reliable and
issued by entities that have adequate
financial resources and operational
capability. These assurances enhance a
broker-dealer’s capital adequacy and,
thereby, protect customers and
counterparties. Users of credit ratings
and others generally agree there must be
substantive threshold standards for
being an NRSRO for the term to have
meaning.159 In essence, the proposed
NRSRO definition is meant to reflect the
fact that the marketplace views a rating
agency’s ratings as credible and reliable.
The Commission requests comment
on all aspects of this analysis and, in
particular, on whether the proposed
NRSRO definition would place a burden
on competition.
rmajette on DSK29S0YB1PROD with PROPOSALS
VIII. Consideration of Impact on the
Economy
For purposes of the Small Business
Regulatory Enforcement Fairness Act of
1996, or ‘‘SBREFA,’’ 160 we must advise
the Office of Management and Budget as
to whether the proposed regulation
constitutes a ‘‘major’’ rule. Under
SBREFA, a rule is considered ‘‘major’’
where, if adopted, it results or is likely
and 1985, respectively, and were designated
together as an NRSRO in 1990. Thomson
BankWatch, Inc. entered the credit rating business
in 1974 and became an NRSRO in 1991. A.M. Best
began issuing credit ratings in 1999 and became an
NRSRO in 2005.
158 See, e.g., Letter from Cheryl Kallem, Chair,
SIA Capital Committee, to Jonathan G. Katz,
Secretary, Commission (July 28, 2003).
159 See, e.g., SEC Hearing Transcript, supra note
30 (November 15, 2002) (testimony of Frank A.
Fernandez, Senior Vice President, Chief Economist
and Director of Research, The Securities Industry
Association and testimony of Gregory A. Root,
Executive Vice President, Dominion Bond Rating
Service Limited).
160 Pub. L. No. 104–121, Title II, 110 Stat. 857
(1996) (codified in various sections of 5 U.S.C., 15
U.S.C. and as a note to 5 U.S.C. 601).
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
to result in: (1) An annual effect on the
economy of $100 million or more (either
in the form of an increase or a decrease);
(2) a major increase in costs or prices for
consumers or individual industries; or
(3) significant adverse effect on
competition, investment or innovation.
If a rule is ‘‘major,’’ its effectiveness
will generally be delayed for 60 days
pending Congressional review. We
request comment on the potential
impact of the proposed rule on the
economy on an annual basis.
Commenters are requested to provide
empirical data and other factual support
for their view to the extent possible.
IX. Regulatory Flexibility Act
Pursuant to section 605(b) of the
Regulatory Flexibility Act (‘‘RFA’’), the
Commission hereby certifies that
proposed Rule 3b–10, would not, if
adopted, have a significant economic
impact on a substantial number of small
entities. Under the RFA, the term ‘‘small
entity’’ shall have the same meaning as
the RFA defined term ‘‘small business.’’
According to section 601(3) of the RFA,
‘‘the term ‘small business’ has the same
meaning as the term ‘small business
concern’ under section 3 of the Small
Business Act (15 U.S.C. 632), unless an
agency, after consultation with the
Small Business Administration and after
opportunity for public comment,
establishes one or more definitions of
such term which are appropriate to the
activities of the agency and publishes
such definition(s) in the Federal
Register.’’ If the agency has not defined
the term for a particular purpose, the
Small Business Act states that ‘‘a small
business concern * * * shall be deemed
to be one which is independently
owned and operated and which is not
dominant in its field of operation.’’ The
Commission has not defined the term
‘‘small entity’’ in the context of NRSROs
for purposes of the RFA. Therefore, for
purposes of this rulemaking, the
Commission is using the broader
definition of ‘‘small business concern’’
as defined in the Small Business Act.
Currently, there are five credit rating
agencies that we believe would meet the
proposed definition of ‘‘NRSRO.’’ Only
two of the NRSROs are independently
owned and operated. However, the two
independently owned NRSROs are
dominant in their respective fields as
one has earned a national reputation for
issuing ratings on insurance companies
and the other on Canadian issuers.
Accordingly, there are no small entities
that currently would meet the proposed
definition of NRSRO.
As noted above, it has been estimated
there are between 100 and 150 entities
that issue credit ratings or credit
PO 00000
Frm 00018
Fmt 4701
Sfmt 4702
analysis.161 It is likely that a substantial
number of these credit rating agencies
are small entities. The proposed
definition could have an impact on one
of these small credit rating agencies if it
sought to become an NRSRO. However,
in this regard, the proposed definition of
NRSRO would closely track the current
process under which the staff issues noaction letters. Thus, while the proposed
definition may impact a small credit
rating agency, such impact would likely
be small.
For the above reasons, the
Commission certifies that proposed Rule
3b–10 would not have a significant
economic impact on a substantial
number of small entities. The
Commission requests comments
regarding this certification. The
Commission requests that commenters
describe the nature of any impact on
small businesses and provide empirical
data to support the extent of the impact.
X. Statutory Authority
Pursuant to the Securities Act of 1933,
and particularly Sections 7, 10, and 19
thereof, 15 U.S.C. 77g, 77j, and 77s, the
Exchange Act, and particularly Sections
3(b), 15, 17, and 23 thereof, 15 U.S.C.
78c(b), 78o(c)(3), 78q, and 78w, the
Investment Company Act of 1940, and
particularly Sections 6c and 38a thereof,
15 U.S.C. 80a–6, 80a–36, the
Commission proposes to adopt
§ 240.3b–10 of Title 17 of the Code of
Federal Regulations in the manner set
forth below.
Text of Proposed Rule
List of Subjects in 17 CFR Part 240
Brokers, Fraud, Reporting and
recordkeeping requirements, Securities.
For the reasons set out in the
preamble, Title 17, Chapter II, of the
Code of Federal Regulations is proposed
to be amended as follows.
PART 240—GENERAL RULES AND
REGULATIONS, SECURITIES
EXCHANGE ACT OF 1934
1. The authority citation for part 240
continues to read in part as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j,
77s, 77z–2, 77z–3, 77eee, 77ggg, 77nnn,
77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 78j,
78j–1, 78k, 78k–1, 78l, 78m, 78n, 78o, 78p,
78q, 78s, 78u–5, 78w, 78x, 78ll, 78mm, 79q,
79t, 80a–20, 80a–23, 80a–29, 80a–37, 80b–3,
80b–4, 80b–11, and 7201 et seq.; and 18
U.S.C. 1350, unless otherwise noted.
*
*
*
*
*
2. Section 240.3b–10 is added to read
as follows:
161 See
E:\TEMP\25APP3.SGM
supra note 156.
25APP3
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 / Proposed Rules
§ 240.3b–10 Definition of ‘‘nationally
recognized statistical rating organization.’’
rmajette on DSK29S0YB1PROD with PROPOSALS
The term nationally recognized
statistical rating organization means any
entity that:
(a) Issues publicly available credit
ratings that are current assessments of
the creditworthiness of obligors with
respect to specific securities or money
market instruments;
VerDate Nov<24>2008
15:07 Oct 19, 2009
Jkt 220001
(b) Is generally accepted in the
financial markets as an issuer of
credible and reliable ratings, including
ratings for a particular industry or
geographic segment, by the predominant
users of securities ratings; and
(c) Uses systematic procedures
designed to ensure credible and reliable
ratings, manage potential conflicts of
interest, and prevent the misuse of
PO 00000
Frm 00019
Fmt 4701
Sfmt 4702
21323
nonpublic information, and has
sufficient financial resources to ensure
compliance with those procedures.
Dated: April 19, 2005.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 05–8158 Filed 4–22–05; 8:45 am]
BILLING CODE 8010–01–P
E:\TEMP\25APP3.SGM
25APP3
]]>Agencies
[Federal Register Volume 70, Number 78 (Monday, April 25, 2005)]
[Proposed Rules]
[Pages 21306-21323]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-8158]
[[Page 21305]]
-----------------------------------------------------------------------
Part IV
Securities and Exchange Commission
-----------------------------------------------------------------------
17 CFR Part 240
Definition of Nationally Recognized Statistical Rating Organization;
Proposed Rule
Federal Register / Vol. 70, No. 78 / Monday, April 25, 2005 /
Proposed Rules
[[Page 21306]]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release Nos. 33-8570; 34-51572; IC-26834; File No. S7-04-05]
RIN 3235-AH28
Definition of Nationally Recognized Statistical Rating
Organization
AGENCY: Securities and Exchange Commission (``Commission'').
ACTION: Proposed rule.
-----------------------------------------------------------------------
SUMMARY: The Commission is publishing for comment a proposed new rule
under the Securities Exchange Act of 1934 (``Exchange Act''), which
would define the term ``nationally recognized statistical rating
organization'' (``NRSRO''). The proposed definition contains three
components that must each be met in order for a credit rating agency to
be an NRSRO. The Commission is also providing interpretations of the
proposed definition of the term ``NRSRO.'' Defining the term ``NRSRO''
and providing interpretations of the definition would increase
transparency with regard to the NRSRO concept.
DATES: Comments should be received on or before June 9, 2005.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (https://
www.sec.gov/rules/proposed.shtml); or
Send an e-mail to rule-comments@sec.gov. Please include
File Number S7-04-05 on the subject line; or
Use the Federal eRulemaking Portal (https://
www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Jonathan G. Katz,
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW,
Washington, DC 20549-0609.
All submissions should refer to File Number S7-04-05. This file
number should be included on the subject line if e-mail is used. To
help us process and review your comments more efficiently, please use
only one method. The Commission will post all comments on the
Commission's Internet Web site (https://www.sec.gov/rules/
proposed.shtml). Comments are also available for public inspection and
copying in the Commission's Public Reference Room, 450 Fifth Street,
NW, Washington, DC 20549. All comments received will be posted without
change; we do not edit personal identifying information from
submissions. You should submit only information that you wish to make
available publicly.
FOR FURTHER INFORMATION CONTACT: Michael A. Macchiaroli, Associate
Director, at (202) 942-0132; Thomas K. McGowan, Assistant Director, at
(202) 942-4886; Randall W. Roy, Branch Chief, at (202) 942-0798; Mark
M. Attar, Special Counsel, at (202) 942-0766; or Rachael Grad,
Attorney, at (202) 942-0183, Division of Market Regulation, Securities
and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-
1001.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
II. The Development of the NRSRO Concept
A. Background
B. History of the NRSRO Concept
C. Commission Reviews of Credit Rating Agencies
1. 1994 Concept Release
2. 1997 Rule Proposal
3. Recent Reviews of Credit Rating Agencies
a. NRSRO Examinations
b. Credit Rating Agency Hearings
c. Report under the Sarbanes-Oxley Act of 2002
d. The 2003 NRSRO Concept Release
D. International Initiatives
III. Discussion
A. Background
B. Proposed Definition of the Term ``NRSRO''
1. The First Component
a. Publicly Available Credit Ratings
b. Issue-Specific Credit Opinions
c. Current Credit Opinions
2. The Second Component
a. General Acceptance in the Financial Markets
b. Limited Coverage NRSROs
3. The Third Component
a. Analyst Experience and Training
b. Number of Ratings per Analyst
c. Information Sources Used in the Ratings Process
d. Contacts with Management
e. Organizational Structure
f. Conflicts of Interest
g. Misuse of Information
h. Financial Resources
i. Standardized Rating Symbols
C. Statistical Models
D. Provisional NRSRO Status
E. Staff No-Action Process
IV. General Request for Comment
V. Paperwork Reduction Act
VI. Consideration of the Costs and Benefits of the Proposed Rule
A. Benefits
B. Costs
VII. Consideration on Burden and Promotion of Efficiency,
Competition, and Capital Formation
VIII. Consideration of Impact on the Economy
IX. Regulatory Flexibility Act
X. Statutory Authority
I. Introduction
In June 2003, the Commission issued a concept release (the ``2003
Concept Release'') soliciting public comment on various issues
regarding credit rating agencies, including whether credit ratings
should continue to be used for regulatory purposes under the federal
securities laws, and, if so, the process of determining whose credit
ratings should be used and the level of oversight to apply to such
credit rating agencies.\1\ To address certain issues raised in response
to the 2003 Concept Release, particularly with regard to the clarity of
whether a credit rating agency is an NRSRO, the Commission is proposing
to define the term ``NRSRO'' in new Exchange Act Rule 3b-10, and to
provide interpretations of that definition. The Commission notes that
this proposal is intended only to address the meaning of the term
``NRSRO'' as it is used by the Commission; it does not attempt to
address many of the broader issues raised in response to the 2003
Concept Release.
---------------------------------------------------------------------------
\1\ Securities Act Release No. 33-8236), 68 FR 35258 (June 12,
2003). The 2003 Concept Release was intended to assist the
Commission in addresing issues identified in its January 24, 2003
report on credit rating agencies, which was required by Congress
under Section 702 of the Arbanes-Oxley Act of 2002. See report on
the Role and Function of Credit Rating AGencies in the operation of
the Securities Markets, As Required by Seciton 7029b) of the
Sarbanes-Oxley Act of 2002, U.S. Securities and Exchange Commission,
January 2003.
---------------------------------------------------------------------------
II. The Development of the NRSRO Concept
A. Background
Since 1975, the Commission has relied in several significant
regulatory areas on credit ratings by rating agencies that the markets
have recognized as credible. These ``nationally recognized statistical
rating organizations,'' or ``NRSROs,'' have typically sought a level of
comfort regarding their status as NRSROs through the no-action letter
process.\2\ To date, nine firms have been identified as NRSROs by the
Commission staff. However, during the 1990s, several credit rating
agencies consolidated so that there are currently five such NRSROs:
A.M. Best Company, Inc. (``A.M. Best''), Dominion Bond Rating Service
Limited (``DBRS''); Fitch,
[[Page 21307]]
Inc. (``Fitch''); Moody's Investors Service Inc. (``Moody's''); and the
Standard & Poor's Division of the McGraw Hill Companies, Inc.
(``S&P'').
---------------------------------------------------------------------------
\2\ See, e.g., Letter from Annette L. Nazareth, Director,
Division of Market Regulation, Commission, to Mari-Anne Pisarri,
Pickard and Djinis LLP (February 24, 2003). For a more detailed
description of the no-action letter process, see also Section III.E.
---------------------------------------------------------------------------
Although the Commission originated the use of the term ``NRSRO''
for use in its rules and regulations, ratings by NRSROs today are used
as benchmarks in federal and state legislation, rules issued by
financial and other regulators, foreign regulatory schemes, and private
financial contracts. Many of these uses specifically refer to the term
``NRSRO'' as used in the Commission's rules and regulations. However,
the Commission has never defined the term ``NRSRO.''
B. History of the NRSRO Concept
The term ``NRSRO'' was originally adopted by the Commission in 1975
solely for use in determining capital charges on different grades of
debt securities under Exchange Act Rule 15c3-1, the Commission's ``net
capital rule.'' \3\ The use of this term enabled the Commission to
distinguish between investment grade and non-investment grade paper in
a reasonably objective fashion. The net capital rule requires broker-
dealers, when computing net capital, to deduct from their net worth
certain percentages of the market value of their proprietary securities
positions. These deductions, often referred to as ``haircuts,'' are
intended to provide a margin of safety against losses that might be
incurred by broker-dealers as a result of market fluctuations in the
prices of, or lack of liquidity in, their proprietary positions. The
Commission determined that it was appropriate to apply a lower haircut
to securities held by a broker-dealer that were rated ``investment
grade'' by a credit rating agency of national repute, because those
securities typically were more liquid and less volatile in price than
securities that were not so highly rated.\4\
---------------------------------------------------------------------------
\3\ See Adoption of Amendments to Rule 15c3-1 and Adoption of
Alternative Net Capital Requirement for Certain Brokers and Dealers,
Release No. 34-11497 (June 26, 1975), 40 FR 29795 (July 16, 1975).
\4\ See, e.g., 17 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H).
---------------------------------------------------------------------------
Over time, as marketplace and regulatory reliance on credit ratings
increased, the Commission's use of the NRSRO concept as a proxy for
regulatory determinations of liquidity and creditworthiness became more
widespread.\5\ Several rules and regulations issued by the Commission
pursuant to the Securities Act of 1933,\6\ the Exchange Act,\7\ and the
Investment Company Act of 1940,\8\ utilize the term ``NRSRO'' and
cross-reference to 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, and NRSRO
ratings can be used as benchmarks for establishing minimum quality
investment standards. Under Rule 2a-7, a money market fund is limited
to investing in securities rated by an NRSRO in the two highest ratings
categories for short-term debt (or unrated securities of similar
quality), and there are limitations on the amount of securities the
fund can hold that are not rated in the highest rating category (or are
not unrated securities of similar quality).\9\ In addition, in
regulations adopted by the Commission under the Securities Act of 1933,
offerings of certain nonconvertible debt, preferred securities, and
asset-backed securities that are rated investment grade by at least one
NRSRO can be registered on Form S-3--the Commission's ``short-form''
registration statement--without the issuer satisfying a minimum public
float test.\10\
---------------------------------------------------------------------------
\5\ The NRSRO concept is currently used in the following
Commission rules: 17 CFR 228.10(e), 229.10(c), 230.134(a)(14),
230.436(g), 239.13, 239.32, 239.33, 240.3a1-1(b)(3), 240.10b-
10(a)(8), 240.15c3-1(c)(2)(vi)(E), (F) and (H), 240.15c3-
3a(b)(1)(i)(C), 240.15c3-1f(d), 240.15c3-3a, Item 14, Note G,
242.101(c)(2), 242.102(d), 242.300(k)(3) and (1)(3), 270.2a-
7(a)(10), 270.3a-7(a)(2), 270.5b-3(c), and 270.10f-3(a)(3).
\6\ See Regulation S-B (17 CFR 228.10) and Regulation S-K (17
CFR 229.10); Rule 134 (17 CFR 230.134); Rule 436 (17 CFR 230.436);
Form S-3 (17 CFR 239.13); Form F-2 (17 CFR 239.32); and Form F-3 (17
CFR 239.33).
\7\ See Rule 3a1-1 (17 CFR 240.3a1-1); Rule 10b-10 (17 CFR
240.10b-10); Rules 101 and 102 of Regulation M (17 CFR 242.101 and
242.102, respectively); and Rule 300 of Regulation ATS (17 CFR
242.300).
\8\ See Rule 2a-7 (17 CFR 270.2a-7); Rule 3a-7 (17 CFR 270.3a-
7); Rule 5b-3 (17 CFR 270.5b-3); and Rule 10f-3 (17 CFR 270.10f-3).
\9\ Under Rule 2a-7 (17 CFR 270.2-7), NRSRO ratings are minimum
requirements; fund advisers must also make an independent
determination that the security presents ``minimal credit risks.''
\10\ Form S-3 (17 CFR 239.13).
---------------------------------------------------------------------------
In addition, Congress has incorporated the term ``NRSRO'' into a
wide range of legislation.\11\ For example, when Congress defined the
term ``mortgage related security'' in Section 3(a)(41) of the Exchange
Act,\12\ as part of the Secondary Mortgage Market Enhancement Act of
1984,\13\ it required, among other things, that such securities be
rated in one of the two highest rating categories by at least one
NRSRO.
---------------------------------------------------------------------------
\11\ See, e.g., 15 U.S.C. 78c(a)(41) (defining the term
``mortgage related security''); 15 U.S.C. 78c(a)(53)(A) (defining
the term ``small business related security''); and 15 U.S.C. 80a-
6(a)(5)(A)(iv)(I) (exempting certain companies from the provisions
of the Investment Company Act of 1940); Gramm-Leach-Bliley Act, Pub.
L. 106-102 (1999); Transportation Equity Act for the 21st Century,
Pub. L. 105-178 (1998); Reigle Community Development and Regulatory
Improvement Act of 1994, Pub. L. 103-325 (1994); Department of
Commerce, Justice, and State, The Judiciary, and Related Agencies
Appropriations Act, FY2001, Pub. L. 106-553 (2000); Higher Education
Amendments of 1992, Pub. L. 102-325 (1992); Housing and Community
Development Act of 1992, Pub. L. 102-550 (1992); Federal Deposit
Insurance Corporation Improvement Act of 1991, Pub. L. 102-242
(1991); and Financial Institutions Reform, Recovery, and Enforcement
Act of 1989, Pub. L. 101-72 (1989).
\12\ 15 U.S.C. 78c(a)(41).
\13\ Pub. L. 98-440, 101, 98 Stat. 1689 (1984).
---------------------------------------------------------------------------
Finally, a number of other federal, state, and foreign laws and
regulations today use the term ``NRSRO.'' For example, the U.S.
Department of Education uses ratings from NRSROs to set standards of
financial responsibility for institutions that wish to participate in
student financial assistance programs under Title IV of the Higher
Education Act of 1965, as amended.\14\ In addition, several state
insurance codes rely on NRSRO ratings in determining appropriate
investments for insurance companies.\15\ The term ``NRSRO'' also has
been used in foreign jurisdictions.\16\
---------------------------------------------------------------------------
\14\ 20 U.S.C. 1070 et seq. and 42 U.S.C. 2751 et seq., 34 CFR
668.15(b)(7)(ii) and (8)(ii).
\15\ For example, the California Insurance Code relies on NRSRO
ratings in allowing California-incorporated insurers to invest
excess funds in certain types of investments. See Cal. Ins. Code
1192.10.
\16\ See, e.g., National Instrument 71-101, The
Multijurisdicitional Disclosure System (Oct. 1, 1998) (Can.).
---------------------------------------------------------------------------
In 1975, when NRSRO ratings first were incorporated in the net
capital rule, the Commission staff determined that the ratings of S&P,
Moody's, and Fitch were used nationally, and that the staff would raise
no questions if these firms were utilized as NRSROs for purposes of the
net capital rule.\17\ Since 1975, the Commission staff has issued NRSRO
no-action letters \18\ to six additional credit rating agencies: (1)
Duff and Phelps, Inc.; \19\ (2) McCarthy, Crisanti & Maffei, Inc.; \20\
(3) IBCA Limited and its subsidiary, IBCA, Inc.; \21\
[[Page 21308]]
(4) Thomson BankWatch, Inc.; \22\ (5) DBRS; \23\ and (6) A.M. Best.\24\
With the exception of A.M. Best and DBRS, each of these additional
firms has since merged with or been acquired by other NRSROs, resulting
in five NRSROs at present.
---------------------------------------------------------------------------
\17\ See, e.g., Letter from Gregory C. Yadley, Staff Attorney,
Division of Market Regulation, Commission, to Ralph L. Gosselin,
Treasurer, Coughlin & Co., Inc. (November 24, 1975).
\18\ For a discussion of the no-action letter process, see
Section III.E.
\19\ See Letter from Nelson S. Kibler, Assistant Director,
Division of Market Regulation, Commission, to John T. Anderson,
Esquire, Lord, Bissell & Brook, on behalf of Duff & Phelps, Inc.
(February 24, 1982).
\20\ See Letter from Michael A. Macchiaroli, Assistant Director,
Division of Market Regulation, Commission, to Paul McCarthy,
President, McCarthy, Crisanti & Maffei, Inc. (September 13, 1983).
\21\ See Letter from Michael A. Macchiaroli, Assistant Director,
Division of Market Regulation, Commission, to Robin Monro-Davies,
President, IBCA Limited (November 27, 1990) and Letter from Michael
A. Macchiaroli, Assistant Director, Division of Market Regulation,
Commission, to David L. Lloyd, Jr., Dewey Ballentine, Bushby, Palmer
& Wood (October 1, 1990).
\22\ See Letter from Michael A. Macchiaroli, Assistant Director,
Division of Market Regulation, Commission, to Gregory A. Root,
President, Thomson BankWatch, Inc. (August 6, 1991) and Letter from
Michael A. Macchiaroli, Associate Director, Division of Market
Regulation, Commission, to Lee Pickard, Pickard and Djinis LLP
(January 25, 1999).
\23\ See supra note 2.
\24\ See Letter from Mark M. Attar, Special Counsel, Division of
Market Regulation, Commission, to Arthur Snyder, President, A.M.
Best (March 3, 2005).
---------------------------------------------------------------------------
The Commission has not adopted a definition of the term ``NRSRO.''
However, through experience from the no-action process, the Commission
staff has developed a number of criteria that it considers when
reviewing NRSRO no-action requests. As a result, under current
practice, the Commission staff reviews a credit rating agency's
operations, position in the marketplace, and other specific factors to
determine whether to grant a no-action letter.
In determining whether to issue an NRSRO no-action letter, the
Commission staff has considered the single most important factor to be
whether the credit rating agency is ``nationally recognized'' in the
United States as an issuer of credible and reliable ratings by the
predominant users of securities ratings. The notion of ``national
recognition'' was designed to help ensure that credit ratings used for
regulatory purposes under Commission rules are credible and can
reasonably be relied upon by the marketplace. Also reviewed in
connection with the no-action letter process is a credit rating
agency's operational capability and ratings process. Included within
this assessment are: (1) The organizational structure of the credit
rating agency; (2) the credit rating agency's financial resources; (3)
the size and quality of the credit rating agency's staff; (4) the
credit rating agency's independence from the companies it rates; (5)
the credit rating agency's rating procedures; and (6) whether the
credit rating agency has internal procedures to prevent the misuse of
nonpublic information and whether those procedures are followed.
C. Commission Reviews of Credit Rating Agencies
1. 1994 Concept Release
Over the years, the Commission has reviewed a number of issues
regarding credit rating agencies, including their regulatory oversight.
In 1994, the Commission issued a concept release soliciting public
comment on the Commission's use of NRSRO ratings (the ``1994 Concept
Release'').\25\ Due to the expanded role played by credit ratings in
Commission rules and regulations, a number of domestic and foreign
credit rating agencies at that time had sought NRSRO no-action letters.
Also, concerns had been expressed that Commission rules and regulations
did not define the term ``NRSRO,'' and that there was no formal
mechanism for monitoring the activities of NRSROs. As a result, the
Commission solicited public comment on the appropriate role of credit
ratings in the federal securities laws, and the need to establish
formal procedures for identifying NRSROs and monitoring their
activities. Most commenters supported the continued use of the NRSRO
concept and recommended that the Commission adopt a formalized process
for identifying NRSROs.\26\
---------------------------------------------------------------------------
\25\ See Nationally Recognized Statistical Rating Organizations,
Release No. 34-34616 (August 31, 1994), 59 FR 46314 (September 7,
1994).
\26\ See, e.g., Letter from Walter J. Schroeder, President,
DBRS, to Jonathan G. Katz, Secretary, Commission (December 20,
1994).
---------------------------------------------------------------------------
2. 1997 Rule Proposal
As a response to the 1994 Concept Release, the Commission, in 1997,
proposed to amend the net capital rule to define the term ``NRSRO.''
\27\ The proposed amendments set forth criteria to be considered by the
Commission in recognizing credit rating agencies as NRSROs, and would
have established an NRSRO application process for credit rating
agencies.
---------------------------------------------------------------------------
\27\ See Capital Requirements for Brokers or Dealers Under the
Securities Exchange Act of 1934, Release No. 34-39457 (December 17,
1997), 62 FR 68018 (December 30, 1997).
---------------------------------------------------------------------------
Although commenters generally supported the Commission's attempt to
define the requirements necessary for a credit rating agency to be
identified as an NRSRO, the Commission did not act upon the 1997 rule
proposal described above as a result of, among other things, the
initiation of broad-based Commission and Congressional reviews of
credit rating agencies.
3. Recent Reviews of Credit Rating Agencies
More recently, the Commission has pursued several approaches to
conduct a thorough and meaningful study of the use of credit ratings in
the federal securities laws, the process of determining which credit
ratings should be used for regulatory purposes, and the level of
oversight to apply to credit rating agencies. Commission efforts
included discussions with credit rating agencies and market
participants, including buy-side firms,\28\ formal examinations of each
of the NRSROs, and public hearings that offered a broad cross-section
of market participants the opportunity to communicate their views on
credit rating agencies and their role in the capital markets.
---------------------------------------------------------------------------
\28\ Retail investor participation in the debt markets often
takes place indirectly through buy-side firms, such as investment
companies.
---------------------------------------------------------------------------
a. NRSRO Examinations
On March 19, 2002, the Commission issued an Order directing
investigation, pursuant to Section 21(a) of the Exchange Act, into the
role of credit rating agencies in the U.S. securities markets.\29\ The
purpose of the Order was to ascertain facts, conditions, practices, and
other matters relating to the role of credit rating agencies in the
U.S. securities markets, and to aid the Commission in assessing whether
to continue to use credit ratings in its rules and regulations under
the federal securities laws and, if so, the categories of acceptable
credit ratings and the appropriate level of regulatory oversight.
---------------------------------------------------------------------------
\29\ See Order In the Matter of the Role of Rating Agencies in
the U.S. Securities Markets Directing Investigation Pursuant to
Section 21(a) of the Securities Exchange Act of 1934, and
Designating Officers for Such Designation (March 19, 2002).
---------------------------------------------------------------------------
The Commission's examination of the NRSROs revealed several
concerns, including those relating to: (i) Potential conflicts of
interest caused by payment by issuers to NRSROs for their ratings; (ii)
exacerbation of those conflicts of interest due to the marketing by the
NRSROs of ancillary services to issuers, such as pre-rating assessments
and corporate consulting; (iii) the potential for the NRSROs, given
their substantial power in the marketplace, to improperly pressure
issuers to pay for ratings; (iv) the potential for the NRSROs, given
their substantial power in the marketplace, to improperly pressure
issuers to purchase ancillary services; (v) the effectiveness of the
NRSROs' existing policies and procedures designed to protect
confidential information; and (vi) difficulties in the Commission's
examinations of NRSROs from, among other things, the lack of
recordkeeping requirements tailored to NRSRO activities, the NRSROs'
assertions that the document retention and production requirements of
the Investment Advisers Act of 1940 are inapplicable to the credit
rating business, and their claims that the First Amendment shields the
NRSROs from producing certain documents to the Commission.
[[Page 21309]]
b. Credit Rating Agency Hearings
The Commission's broad-based study of credit rating agencies
included public hearings held on November 15 and 21, 2002, that
addressed credit rating agencies operating in U.S. securities
markets.\30\ Panel participants represented various views, including
those of credit rating agencies, broker-dealers, buy-side firms,
issuers, and the academic community.
---------------------------------------------------------------------------
\30\ The Current Role and Function of Credit Rating Agencies in
the Operation of the Securities Markets, Hearings Before the U.S.
Securities and Exchange Commission (November 15 and 21, 2002) (``SEC
Hearing on Credit Rating Agencies''). Full hearing transcripts are
available on the Commission's Web site at https://www.sec.gov/
spotlight/ratingagency.htm [hereinafter ``SEC Hearing Transcript''].
---------------------------------------------------------------------------
Topics addressed during the hearings included the current role and
functioning of credit rating agencies, information flow in the credit
rating process, concerns regarding credit rating agencies (e.g.,
potential conflicts-of-interest), and the regulatory treatment of
credit rating agencies (including concerns regarding potential barriers
to entry).
Most hearing participants favored the regulatory use of credit
ratings issued by NRSROs as a simple, efficient benchmark of credit
quality, and suggested that regulatory standards for NRSROs were
necessary for this concept to have meaning and reliability.\31\
---------------------------------------------------------------------------
\31\ See, e.g., SEC Hearing Transcript, supra note 30 (November
15, 2002) (testimony of Gregory A. Root, Executive Vice President,
DBRS).
---------------------------------------------------------------------------
Many participants expressed concern about the existing NRSRO no-
action letter process.\32\ Suggestions to improve the process included
(i) that the Commission should specify the information credit rating
agencies should provide when requesting NRSRO no-action letters; and
(ii) that the Commission review the staff's work in evaluating
satisfaction of the NRSRO criteria.\33\ Some suggested that NRSRO no-
action requests be completed in a more timely fashion and some noted
that the Commission might promote competition in the credit rating
industry by explicitly permitting credit rating agencies that
specialize in particular sectors to receive NRSRO no-action
letters.\34\
---------------------------------------------------------------------------
\32\ See, e.g., Written Statement of Paul Saltzman, Executive
Vice President and General Counsel, The Bond Market Association),
SEC Hearing on Credit Rating Agencies, supra note 30 (November 21,
2002).
\33\ Id.
\34\ See, e.g., Written Statement of Yasuhiro Harada, Senior
Executive Managing Director, Rating and Investment Information,
Inc., SEC Hearing on Credit Rating Agencies, supra note 30 (November
21, 2002).
---------------------------------------------------------------------------
Some ratings users and issuers suggested that the Commission
consider more substantive regulation of credit rating agencies (e.g.,
to address potential conflicts of interest), and engage in more active
oversight of them (e.g., monitoring compliance with the NRSRO
criteria).\35\
---------------------------------------------------------------------------
\35\ See, e.g., Written Statement of Amy Lancellotta, Senior
Counsel, Investment Company Institute, SEC Hearing on Credit Rating
Agencies, supra note 30 (November 21, 2002).
---------------------------------------------------------------------------
Concerns were raised by hearing participants regarding the special
access of subscribers to credit rating agency personnel, particularly
given the exclusion from Regulation FD available for disclosures to
credit rating agencies.\36\ While the larger credit rating agencies
make ratings and the basic rating rationale available simultaneously to
subscribers and non-subscribers, subscribers may also have direct
access to credit rating agency analysts.\37\ Because of this direct
access, there is a greater risk that nonpublic material information may
be communicated to subscribers.
---------------------------------------------------------------------------
\36\ See, e.g., SEC Hearing Transcript, supra note 30 (November
15, 2002) (testimony of Malcolm S. Macdonald, Vice President--
Finance and Treasurer, Ford Motor Company). See also Selective
Disclosure and Insider Trading, Release No. 34-43154 (August 15,
2000), 65 FR 51716 (August 24, 2000). Generally, Regulation FD
prohibits an issuer of securities, or persons acting on behalf of
the issuer, from communicating material nonpublic information to
certain enumerated persons--in general, securities market
professionals or others who may use the information for trading--
unless the information is publicly disclosed. When Regulation FD was
adopted, the Commission exempted credit rating agencies--not just
NRSROs--from Regulation FD, on the condition that the material
nonpublic information is communicated to a credit rating agency
solely for the purpose of developing a credit rating and that the
rating is publicly available. In addition to the specific rating
agency exemption in Regulation FD, credit rating agencies may be
able to avail themselves of the exemption for ``persons who
expressly agree to maintain the disclosed information in
confidence.'' 17 CFR 243.100(b)(2)(ii).
\37\ Id.
---------------------------------------------------------------------------
c. Report Under the Sarbanes-Oxley Act of 2002
Coincident with these Commission initiatives, Congress in Section
702 of the Sarbanes-Oxley Act of 2002, required that the Commission
conduct a study of credit rating agencies and submit a report on that
study to the President and Congress (the ``Report''). The Commission
submitted the Report to the President and Congress on January 24,
2003.\38\ The Report addressed, among other things, each of the topics
identified for Commission study in Section 702, including the role of
credit rating agencies and their importance to the securities markets,
impediments faced by credit rating agencies in performing that role,
measures to improve information flow to the market from credit rating
agencies, barriers to entry into the credit rating business, and
conflicts of interest faced by credit rating agencies.\39\
---------------------------------------------------------------------------
\38\ See supra note 1.
\39\ Sarbanes-Oxley Act of 2002, Pub. L. 107-204, Section
702(b), 116 Stat. 745 (2002).
---------------------------------------------------------------------------
d. The 2003 NRSRO Concept Release
To further assist the Commission in addressing issues identified in
the Report, the Commission published the 2003 Concept Release on June
4, 2003, seeking comment on a number of issues relating to credit
rating agencies. These issues included whether credit ratings should
continue to be used for regulatory purposes under the federal
securities laws, and, if so, the process of determining whose credit
ratings should be used, and the level of oversight to apply to such
credit rating agencies. Issues discussed during the Commission's two
days of public hearings on credit rating agencies were also addressed
in the 2003 Concept Release.
Most of the 46 commenters responding to the 2003 Concept Release
supported retention of the NRSRO concept. They generally represented
that, among other things, eliminating the NRSRO concept would be
disruptive to the capital markets,\40\ and would be costly and
complicated to replace.\41\ Only four commenters supported elimination
of the concept,\42\ and there was limited discussion of regulatory
alternatives.\43\
---------------------------------------------------------------------------
\40\ See, e.g., Letter from Leo C. O'Neill, President, Standard
& Poor's, to Jonathan G. Katz, Secretary, Commission (July 28,
2003).
\41\ See, e.g., Letter from Gregory V. Serio, Superintendent,
New York Insurance Department, Chair, NAIC Rating Agency Working
Group, National Association of Insurance Commissioners, to
Commission (July 28, 2003).
\42\ See, e.g., Letter from Lawrence J. White, Professor of
Economics, Stern School of Business, New York University, to
Commission (July 25, 2003).
\43\ See, e.g., Letter from Frank Partnoy, University of San
Diego School of Law, to Jonathan G. Katz, Secretary, Commission
(July 28, 2003).
---------------------------------------------------------------------------
Most commenters supported improving the clarity of the process for
identifying NRSROs to the extent credit ratings continue to be relied
upon in Commission rules. Specifically, commenters generally supported
the Commission's suggestions to specify more detail in what credit
rating agencies need to provide to obtain an NRSRO no-action
letter.\44\ Some also generally supported greater transparency
regarding the NRSRO concept, for example, by identifying
[[Page 21310]]
NRSROs through Commission action versus the existing no-action letter
process.\45\
---------------------------------------------------------------------------
\44\ See, e.g., Letter from Barbara Roper, Director of Investor
Protection, Consumer Federation of America, to Jonathan G. Katz,
Secretary, Commission (July 28, 2003).
\45\ See, e.g., Letter from Steven C. Nelson, Director of
Taxable Money Market Research, Fidelity Investments Money
Management, Inc., to Jonathan G. Katz, Secretary, Commission (July
25, 2003).
---------------------------------------------------------------------------
A few commenters represented that the current NRSRO criteria, as
set forth in the 2003 Concept Release, create barriers to entry for new
entrants and that the standards for determining NRSRO status should be
lowered.\46\ Others disagreed and represented that the current NRSRO
criteria should not be diluted.\47\ Most commenters supported NRSRO
criteria designed to limit conflicts of interest in the credit rating
business.\48\ There was also general support for recognizing credit
rating agencies that confine their activities to a limited sector of
the debt market \49\ or a limited geographic area.\50\
---------------------------------------------------------------------------
\46\ See, e.g., Letter from LACE Financial Corp. (July 25,
2003).
\47\ See, e.g., Letter from Grace Hinchman, Senior Vice
President, Public Affairs, Financial Executives International, to
Jonathan G. Katz, Secretary, Commission (July 25, 2003).
\48\ See, e.g., Letter from John M. Ramsey, Senior Vice
President and Regulatory Counsel, The Bond Market Association, to
Jonathan G. Katz, Secretary, Commission (July 28, 2003).
\49\ See, e.g., Letter from Jeffrey P. Neubert, President and
CEO, The New York Clearing House Association L.L.C., to Jonathan G.
Katz, Secretary, Commission (July 31, 2003).
\50\ See, e.g., Letter from Naohiko Matsuo, Director for
International Financial Markets, Financial Services Agency,
Government of Japan, to Jonathan G. Katz, Secretary, Commission
(July 25, 2003).
---------------------------------------------------------------------------
Most commenters supported the concept of regulatory oversight of
NRSROs, at a minimum, to determine whether a credit rating agency
continues to meet the NRSRO criteria on an ongoing basis.\51\
Commenters also recommended that NRSROs should be subject to periodic
Commission examinations.\52\
---------------------------------------------------------------------------
\51\ See, e.g., Letter from Amy B.R. Lancellotta, Senior
Counsel, Investment Company Institute, to Jonathan G. Katz,
Secretary, Commission (July 28, 2003).
\52\ See, e.g., supra note 41.
---------------------------------------------------------------------------
D. International Initiatives
In recent years, there have also been several international
initiatives involving credit rating agencies. In February 2003, the
Technical Committee of the International Organization of Securities
Commissions (``IOSCO''),\53\ of which the Commission is a member,
created a task force to study issues concerning credit rating agencies,
and in September 2003 IOSCO published ``Principles Regarding the
Activities of Credit Rating Agencies,'' \54\ a set of high-level
objectives for regulators, credit rating agencies, and other market
participants. In February 2004, the IOSCO Technical Committee formed a
Chairmen's Task Force for the purpose of developing a voluntary code of
conduct for credit rating agencies providing guidance on ways credit
rating agencies could implement the Principles in practice, leading to
the December 2004 publication by IOSCO of a ``Code of Conduct
Fundamentals for Credit Rating Agencies.'' \55\ The Code, among other
things, addresses how credit rating agencies can protect their
analytical independence, eliminate or manage conflicts of interest, and
help ensure the confidentiality of nonpublic information shared with
them by issuers.
---------------------------------------------------------------------------
\53\ IOSCO consists of 175 securities market regulators that
have agreed to cooperate in order to promote high standards of
regulation and to maintain efficient and sound domestic and
international securities markets.
\54\ ``IOSCO Statement of Principles Regarding the Activities of
Credit Rating Agencies,'' The Technical Committee, IOSCO (September
25, 2003). See also ``Report on the Activities of Credit Rating
Agencies,'' The Technical Committee, IOSCO (September 2003).
\55\ See ``Code of Conduct Fundamentals for Credit Rating
Agencies,'' The Technical Committee of IOSCO (December 2004).
---------------------------------------------------------------------------
III. Discussion
A. Background
The Commission is proposing to define the term ``NRSRO'' in new
Exchange Act Rule 3b-10. The proposed definition would be composed of
three components, which the Commission preliminarily believes to be the
most important criteria in determining whether an entity's ratings
should be relied upon for purposes of the securities laws and
Commission rules and regulations. In addition, the Commission is
providing interpretations of the proposed definition.
Specifically, the Commission is proposing to define the term
``NRSRO'' as an entity (i) that issues publicly available credit
ratings that are current assessments of the creditworthiness of
obligors with respect to specific securities or money market
instruments; (ii) is generally accepted in the financial markets as an
issuer of credible and reliable ratings, including ratings for a
particular industry or geographic segment, by the predominant users of
securities ratings; and (iii) uses systematic procedures designed to
ensure credible and reliable ratings, manage potential conflicts of
interest, and prevent the misuse of nonpublic information, and has
sufficient financial resources to ensure compliance with those
procedures.
The components of the proposed definition are designed to determine
those credit rating agencies whose ratings are sufficiently reliable to
be used for a variety of regulatory purposes, such as for purposes of
the net capital rule. For example, the principal purposes of the net
capital rule are to protect customers and other market participants
from broker-dealer failures and to enable those firms that fall below
the minimum net capital requirements to liquidate in an orderly fashion
without the need for a formal proceeding or financial assistance from
the Securities Investor Protection Corporation. The net capital rule
requires different minimum levels of capital based upon the nature of
the firm's business and whether the broker-dealer handles customer
funds or securities. In relying on credit ratings believed to be
sufficiently reliable, the Commission is using those ratings as a means
to evaluate the liquidity as well as the creditworthiness of certain
securities held by a broker-dealer in establishing a sufficient capital
cushion.
B. Proposed Definition of the Term ``NRSRO''
1. The First Component
The first component of the proposed NRSRO definition would limit
the definition to entities that issue publicly available credit ratings
that are current assessments of the creditworthiness of obligors with
respect to specific securities or money market instruments.
a. Publicly Available Credit Ratings
In the 2003 Concept Release, the Commission inquired whether it
should address concerns that certain credit rating agencies make their
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 ratings for regulatory purposes. The
majority of commenters agreed that credit rating agencies whose ratings
are used for regulatory purposes under the Commission's rules and
regulations should agree to make public dissemination of their ratings
on a widespread basis at no cost.\56\
---------------------------------------------------------------------------
\56\ See, e.g., Letter from Denise Voigt Crawford, Securities
Commissioner, Texas State Securities Board, to Jonathan G. Katz,
Secretary, Commission (July 28, 2003).
---------------------------------------------------------------------------
Commenters generally represented that the publication of credit
ratings (i) enhances the transparency and efficiency of the market,
(ii) helps prevent potential selective disclosure of material nonpublic
information obtained by a credit rating agency under Regulation FD, and
(iii) and allows for
[[Page 21311]]
ratings comparability.\57\ The commenters also said that a credit
rating should not be considered to be ``publicly disseminated'' if
access to it is not readily available on a widespread basis.\58\
---------------------------------------------------------------------------
\57\ See, e.g., Letter from Raymond McDaniel, President,
Moody's, to Jonathan G. Katz, Secretary, Commission (July 28, 2003).
\58\ Id.
---------------------------------------------------------------------------
One commenter noted that a credit rating agency should not be
required to disclose ratings to the public when there is a specific
prior agreement between the credit rating agency and an issuer as to
certain prescribed conditions for not publishing the issuer's rating
(e.g., in the case of ``private'' ratings, in which a credit rating
agency agrees to provide its rating of an issuer only to the
issuer).\59\ Another commenter suggested that NRSROs should permit
others, such as publishers of financial information, to freely
distribute new rating information without limitations.\60\ One
commenter also cautioned the Commission against involving itself in the
determination of an NRSRO's pricing models.\61\ This commenter
represented that NRSROs should be allowed to charge whatever price the
market will bear.\62\ Another commenter expressed concern that
requiring NRSROs to publish their credit ratings at no cost may result
in higher prices for issuers and others who pay for an NRSRO's
services.\63\
In response to these comments, the Commission is proposing that, in
order to meet the definition of the term ``NRSRO,'' a credit rating
agency must issue credit ratings that are publicly available. The
Commission is also interpreting ``publicly available,'' as used in the
definition, to mean that credit ratings used for regulatory purposes
under Commission rules must be disseminated on a widespread basis at no
cost. In this context, the rating could be published in a readily
accessible manner on the credit rating agency's internet Web site. The
Commission believes that it is important for credit ratings used for
regulatory purposes to be publicly available, as public availability--
at no cost--should assure wide dissemination of ratings and provide the
opportunity for the marketplace to judge the credibility and
reliability of an entity's credit ratings.
---------------------------------------------------------------------------
\59\ See, e.g., Letter from Yasuhiro Harada, Executive Vice
President, Rating and Investment Information, Inc., to Jonathan G.
Katz, Secretary, Commission (July 28, 2003).
\60\ See, e.g., Letter from David Colling, Product Director, ABS
Reports (UK) Limited), to Jonathan G. Katz, Secretary, Commission
(July 31, 2003).
\61\ See, e.g., Letter from James A. Kaitz, President and CEO,
Association for Financial Professionals, to Jonathan G. Katz,
Secretary, Commission (July 28, 2003).
\62\ Id.
\63\ See, e.g., Letter from Richard Raeburn, Chief Executive,
and John Grout, Technical Director, The Association of Corporate
Treasurers, United Kingdom, to Jonathan G. Katz, Secretary,
Commission (August 8, 2003).
---------------------------------------------------------------------------
This approach is consistent with the views of most commenters 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. The Commission notes that in proposing to define
the term ``NRSRO'' as an entity that makes its credit ratings publicly
available, the public availability reference only would apply to the
credit rating itself (i.e., the rating symbol), and not to other
information otherwise developed by the credit rating agency (e.g., the
credit rating agency's rating rationale). This approach should not
result in NRSROs charging higher fees for their services because it
would not require a credit rating agency to make available at no cost
the analysis underlying its rating.\64\ The Commission notes that this
approach is also consistent with the current practices of many credit
rating agencies, including each of the current NRSROs, that already
publish their credit ratings on a widespread basis at no cost.
---------------------------------------------------------------------------
\64\ In connection with the Commission's review of issues
concerning credit rating agencies, commenters have consistently
represented that they typically subscribe to a rating agency's
services primarily to understand the analysis underlying the rating
agency's ratings--not solely for the credit rating itself. For
example, during the Commission's 2002 credit rating agency hearings,
representatives of users of credit ratings (e.g., from mutual fund
companies and broker-dealers) indicated that they review research
that is done by credit rating agencies to assess credit risk for the
securities they purchase within their portfolios. See, e.g., SEC
Hearing Transcript, supra note 30 (November 15, 2002) (testimony of
Deborah A. Cunningham, Senior Vice President and Senior Portfolio
Manager, Federated Investors, Inc., and testimony of Cynthia L.
Strauss, Director of Taxable Bond Research, Fidelity Investments
Money Management, Inc.).
---------------------------------------------------------------------------
Questions: How should it be determined whether an NRSRO is making
its credit ratings readily available on a widespread basis? Should our
rule specify the manner and methods that must be used to distribute
ratings? Should internet posting itself be sufficient?
b. Issue-Specific Credit Opinions
The Commission is aware that credit rating agencies often issue
different types of credit ratings that can reflect, among other things,
the creditworthiness of specific securities or obligations, or the
general creditworthiness of specific entities. Because the Commission's
regulatory use of the term ``NRSRO'' primarily relates to credit
ratings on specific securities or obligations, the Commission, in its
proposed definition of the term ``NRSRO,'' is limiting the availability
of the NRSRO concept to entities that issue such ratings.
The Commission is proposing to clarify this element of the proposed
NRSRO definition because credit rating agencies that do not issue
credit ratings on specific securities, but instead issue credit ratings
on the general creditworthiness of specific entities, have requested
NRSRO no-action relief. The risk of loss on different debt instruments
of the same issuer can vary considerably depending on the terms written
into a security's legal documentation. Therefore, applying a single
``issuer'' rating to all of an issuer's outstanding debt instruments
could be misleading, in the context of the regulatory use of NRSRO
ratings, and have adverse regulatory implications.
Questions: Should a credit rating agency that does not rate
specific securities or money market instruments be included in the
definition of NRSRO? If so, under what circumstances?
c. Current Credit Opinions
The proposed definition also attempts to ensure that only
``current'' credit ratings--meaning that such ratings are actively
monitored and updated appropriately on a continuous basis--be used for
regulatory purposes under the federal securities laws. The Commission
believes that credit ratings used for regulatory purposes should be
actively monitored on a continuous basis and confirmed, upgraded, or
downgraded, if and when necessary. The Commission's reliance on credit
ratings from a credit rating agency that are not current, and thus, may
not even reflect the credit rating agency's own view as to the
creditworthiness of a security, could interfere with the intended
regulatory uses of the NRSRO rating.
The first component of the proposed definition would require a
credit rating agency to issue credit ratings that are ``current
assessments'' of the creditworthiness of specific securities or money
market instruments. This component may help to ensure that persons
relying on a rating for regulatory purposes in Commission rules and
regulations can have confidence, at any given time, that the rating
reflects the credit rating agency's current view.
Under the proposed definition, the Commission would interpret
``current assessments'' to mean that a credit rating agency's published
credit ratings reflect its opinion as to the creditworthiness of a
security or money
[[Page 21312]]
market instrument as of the time the rating was issued and until the
rating is changed or withdrawn. Under this interpretation, a credit
rating agency could meet the ``current assessments'' element of the
proposed definition if it has and follows procedures designed to ensure
that its ratings are reviewed and, if necessary, updated on the
occurrence of material events, including significant sector or issue-
specific events. By including in the NRSRO definition that a credit
rating agency's ratings need to be ``current assessments,'' the
Commission is responding to comments received in response to the 2003
Concept Release that a requirement that NRSRO ratings be kept
``current'' is desirable.\65\
---------------------------------------------------------------------------
\65\ See, e.g., supra note 63.
---------------------------------------------------------------------------
Further, although the Commission is proposing to define the term
``NRSRO'' to require an NRSRO's ratings to be current, the Commission
is not proposing to prescribe a specific time period within which an
NRSRO's ratings would need to be updated. Specifying a time period
within which a credit rating agency must update or affirm a rating
might be problematic because the appropriate time period for responding
to a material event may vary considerably based on, for example, the
complexity of an issuer or the specific security being rated.
Accordingly, it may be appropriate for a credit rating agency to have
the flexibility to respond to material events relating to its ratings
on a case-by-case basis. This approach responds to comments that the
Commission should not set detailed standards as to when a rating agency
should update its ratings.\66\
---------------------------------------------------------------------------
\66\ See, e.g., supra note 59.
---------------------------------------------------------------------------
Questions: Should the Commission provide additional interpretation
regarding what it means for a credit rating agency's credit ratings to
be ``current assessments''? Should the Commission specify the time
period? Will the proposed rule's provisions provide sufficient
assurance to the markets that ratings are current?
2. The Second Component
a. General Acceptance in the Financial Markets
As discussed above, the notion that a credit rating agency be
``nationally recognized'' for purposes of the NRSRO concept was
designed to ensure that credit ratings used for regulatory purposes are
credible and reliable, and are reasonably relied upon by the
marketplace. Responding to most commenters to the 2003 Concept Release
that NRSRO status should be based primarily on a credit rating agency's
wide acceptance in the marketplace, the second proposed component of
the ``NRSRO'' definition focuses on whether a credit rating agency is
generally accepted in the financial markets as an issuer of credible
and reliable ratings by the predominant users of securities ratings.
The Commission is proposing that the second component of the NRSRO
definition require a credit rating agency to be generally accepted in
the financial markets. Such acceptance would reflect the markets'
belief in the credibility and reliability of the ratings provided by
the credit rating agency and should provide some level of assurance to
those relying on ratings with regard to the dependability and
consistency of the ratings for a variety of regulatory purposes. For
example, net capital calculations and haircuts that are determined
through use of these credit ratings are more likely to be reliable than
those determined without the use of such ratings and, thus, could be
more likely to protect customers and other market participants from
harm in the event of a broker-dealer failure.
Further, linking the evaluation of a credit rating agency's ratings
to the views of the predominant users of securities ratings would be
helpful. Predominant users generally include financial market
participants who hold large inventories of proprietary debt securities,
preferred stock, and commercial paper, such as broker-dealers, mutual
funds, pension funds, and insurance companies. These firms--given their
large inventories of rated fixed income securities--generally have
developed sophisticated internal credit rating departments which rate
issuers and counterparties. However, they also rely on external ratings
from credit rating agencies to compare against and test their internal
rating and analysis. Given the importance of credit ratings to the
business of these market participants, and to the stability of the
financial markets as a whole, the Commission believes that
incorporating their views into the definition of NRSRO provides a
certain level of credibility and reliability to NRSRO ratings.
The Commission proposes that a credit rating agency could meet the
second component of the NRSRO definition through a variety of objective
means. For example, in appropriate circumstances, a credit rating
agency could do so through statistical data that demonstrates market
reliance on the credit rating agency's ratings (e.g., market movements
in response to ratings changes). A credit rating agency also might be
able to satisfy the second component if authorized officers of users of
securities ratings representing a substantial percentage of the
relevant market attest that the credit rating agency's ratings are
credible and actually relied on by the users.
Questions: How else could the Commission define the term ``NRSRO''
in order for users of a credit rating agency's ratings to determine
whether such ratings are credible and are reasonably relied upon by the
marketplace? Are the approaches discussed above useful for determining
whether a credit rating agency meets the second component of the
proposed definition? Are there other types of information that would be
appropriate? For example, should the fact that a credit rating agency
has many subscribers support a finding that the credit rating agency
satisfies the second component? What types of statistical data could be
relied on to determine if a credit rating agency's credit ratings are
relied on by the marketplace? What standards should be considered to
assess such statistical data? Should the views of issuers be a relevant
consideration in determining whether a credit rating agency meets the
second component of the NRSRO definition?
b. Limited Coverage NRSROs
Commenters at both the Commission's credit rating agency hearings
and responding to the 2003 Concept Release generally supported the idea
that the definition of the term ``NRSRO'' could include credit rating
agencies that confine their activities to limited sectors of the debt
market or to limited (or largely non-U.S.) geographic areas. While
several commenters suggested that the Commission distinguish between
full- and limited-coverage NRSROs,\67\ others represented that credit
rating agencies should only be able to meet the definition as full-
coverage NRSROs because, in their view, it would be difficult for
limited coverage NRSROs to provide a full and accurate assessment of
credit risks without a broader expertise in credit risk assessment.\68\
---------------------------------------------------------------------------
\67\ Id.
\68\ See, e.g., Letter from Jonathan C. Conley, Federated
Investment Management Company, to Jonathan G. Katz, Secretary,
Commission (July 28, 2003).
---------------------------------------------------------------------------
Based on the staff's experience in issuing no-action letters to
credit rating agencies, a credit rating agency that has developed a
general acceptance in the financial markets for a limited sector of the
debt market or a limited geographic area could meet the NRSRO
definition. As noted in Section II.B., NRSRO no-action letters have
been provided to
[[Page 21313]]
such firms in the past. In these instances, even though the credit
rating agencies were generally accepted in the financial markets for a
limited sector of the debt market or a limited geographic area, their
market acceptance was based on the credibility and reliably of their
ratings. Accordingly, the regulatory use of those ratings in Commission
rules and regulations was appropriate and consistent with the purposes
underlying the NRSRO concept.
Questions: Should a credit rating agency that is recognized by the
financial marketplace for issuing credible and reliable ratings within
a limited sector or geographic area meet the NRSRO definition only for
its ratings within such sector or geographic area, or more broadly? If
a credit rating agency meets the NRSRO definition only with respect to
its ratings within a particular sector or geographic area, would the
NRSRO classification interfere with the credit rating agency's ability
to expand its business? How should ratings from such an NRSRO be
identified so that broker-dealers and other users of NRSRO ratings for
regulatory purposes can determine which credit ratings from the NRSRO
may be used for regulatory purposes? We noted above that commenters
mentioned that it would be difficult for limited coverage NRSROs to
provide a full and accurate assessment of credit risks without a
broader expertise in credit risk assessment. We request further comment
on this view given our proposal to permit limited coverage NRSROs.
3. The Third Component
The third proposed component of the NRSRO definition is designed to
ensure that to meet the definition of the term ``NRSRO,'' a credit
rating agency uses systematic procedures designed to ensure credible
and reliable ratings, manage conflicts of interest, and prevent the
misuse of nonpublic information. It also addresses the need for credit
rating agencies to have sufficient financial resources to ensure
compliance with such procedures, if they are to meet the definition.
The Commission preliminarily believes that including in the
proposed definition the requirement that an entity use systematic
rating procedures in producing credit ratings should help to ensure
that NRSRO ratings are based on a thorough credit analysis of issuers
and their financial obligations. This type of analysis should, in turn,
assist the credit rating agency in producing credible and reliable
ratings, which as discussed above, would further the purposes
underlying the regulatory uses of NRSRO ratings.
The Commission preliminarily believes that the following would be
important for assessing whether a credit rating agency meets the third
component of the proposed definition: (i) The experience and training
of a firm's rating analysts (pertaining to the analysts' ability to
understand and analyze relevant information); (ii) the average number
of issues covered by analysts (relevant to whether analysts are capable
of continuously monitoring and assessing relevant developments relating
to their ratings); (iii) the information sources reviewed and relied
upon by the credit rating agency and how the integrity of information
utilized in the ratings process is verified (relating to the extent and
quality of information upon which a firm's ratings are based); (iv) the
extent of contacts with the management of issuers, including access to
senior level management and other appropriate parties (pertaining to,
among other things, the quality and credibility of an issuer's
management and to attempt to better understand the issuer's financial
and operational condition); (v) the organizational structure of the
credit rating agency (to demonstrate, among other things, the firm's
independence from the companies it rates and from potential conflicts
of interest that may result from related businesses or those of an
affiliate); (vi) how the credit rating agency identifies and manages or
proscribes conflicts of interest affecting its ratings business; (vii)
how the credit rating agency monitors and enforces compliance with its
procedures designed to prohibit the misuse of material, nonpublic
information; and (viii) the financial resources of the credit rating
agency (regarding whether, among other things, a credit rating agency
has sufficient financial resources to e
