Ask FERF about ... credit rating agencies.

The comment period ends on June 9 for the U.S. Securities and Exchange Commission (SEC)'s proposed rule on the Definition of Nationally Recognized Statistical Rating Organization (NRSRO). Under the proposed rule, any credit rating agency (CRA) that meets this codified definition would effectively be a NRSRO.

While the SEC originated use of "NRSRO" in its rules, it has never previously defined the term, although the use of the concept in regulatory determinations of liquidity and creditworthiness has become widespread. Ratings by NRSROs are used as benchmarks in federal and state legislation, financial regulations and private financial contracts.

According to the Basel Committee on Banking Supervision, over 100 CRAs are in operation worldwide, but only five CRAs hold NRSRO status: A.M. Best Co. Inc., Dominion Bond Rating Service Limited, Fitch Inc., Moody's Investors Service Inc., and the Standard & Poor's Division of the McGraw Hill Cos. Inc.

Currently, a CRA achieves NRSRO status by requesting a staff no-action letter from the SEC that states that SEC staff will not recommend enforcement action against persons who use an agency's credit ratings for purposes of the SEC's net capital rule. The notion of national recognition was designed to help ensure that credit ratings used under SEC rules are credible and can reasonably be relied upon by the marketplace.

In connection with the no-action letter, an assessment of a CRA's operational capability and ratings process is conducted that considers the following (related to the CRA); its organizational structure, financial resources; the size and quality of its staff, its independence from the companies it rates; its rating procedures; and, whether it has internal procedures to prevent the misuse of nonpublic information and whether those procedures are followed.

Based on the proposed rule, SEC staff will now include expiration dates in its no-action letters. And, under new considerations or changing conditions, NRSRO status previously granted to a CRA is subject to change.

The proposed rule states that the term NRSRO means any entity that:

* Issues publicly available credit ratings that are current assessments of the credit-worthiness of obligors with respect to specific securities or money market instruments. The public availability would apply only to the credit rating itself, not to other information otherwise developed by CRAs. This should not result in NRSROs charging higher fees and is consistent with the current practices.

* 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. The SEC believes that incorporating the views of broker-dealers, mutual funds, pension funds and insurance companies into the NRSRO definition provides credibility and reliability for those ratings. These firms not only have sophisticated internal credit rating departments, but also rely on external credit ratings for comparison purposes.

Based on SEC staff's past experience in issuing no-action letters, the proposal notes that a CRA that has developed a general acceptance in the financial markets for a limited geographic area could meet the NRSRO definitions. Since this differs from current practice, and is counter to comments previously received by the SEC, the commission is seeking further comment on this view.

* 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 SEC has preliminarily identified criteria that would determine if a CRA meets the third component of the NRSRO definition, such as: experience and training of analysts, average number of issues covered, information sources relied upon, extent of contact with an issuer's management and how a CRA identifies and managers conflicts of interest affecting its ratings business.

Separate from the proposed rule, in testimony made on March 9 before the U.S. Senate Committee on Banking, Housing and Urban Affairs, SEC Chairman William H. Donaldson noted that the current NRSROs have sought to craft a voluntary framework that will enhance oversight by providing a means by which the SEC can assess, on an ongoing basis, whether an NRSRO continues to meet the NRSRO definition.

Donaldson said that even if the credit rating industry does adopt such a framework, it would not give the commission the same authority that actual legislative authority could.

The complete text of the proposed rule and related comments are on the SEC Web site at www.sec.gov/rules/proposed/33-8570fr.pdf. Financial Executives Research Foundation (FERF) expects to analyze related comments and a survey of FEI members in upcoming research.

Cheryl de Mesa Graziano ([e-mail]) is Director of Research for Financial Executives Research Foundation (FERF).

contributed by FERF