Demystifying the rating agencies. (Credit Ratings).

The focus on recent corporate scandals has also brought congressional attention to--and scrutiny of--the inner workings, the power and the role of the credit rating agencies.

Where were the rating agencies? Since the widely publicized failures of Enron Corp., WorldCom Inc. and others, there has been a public outcry--fueled by the press--for a re-examination of the role of credit rating agencies. This raises a basic curiosity: While the functioning of rating agencies has become key to the global financial system, there has been scant information available on how the agencies function. Finance courses typically do not discuss their activities, and few texts provide any more than a cursory comment. Furthermore, while access to capital is widely available from an array of lenders and investors, credit ratings are established by a small group of raters using confidential procedures.

This situation is being scrutinized by the U.S. House of Representatives--its Financial Services Committee held hearings in early April--and the U.S. Senate, which held hearings in 2002. In addition, the Sarbanes-Oxley Act ([section]702b) requires the Securities and Exchange Commission (SEC) to review the functioning of the credit rating agencies and the entire process of awarding the nationally recognized statistical rating organization (NRSRO) designation, now held by four organizations: Moody's Investors Services, Standard & Poor's, Fitch Ratings Ltd. and Dominion Bond Rating Services in Canada. Developed by the SEC in 1975, the NRSRO designation has come to be accepted as a sort of "quasi-official approval of the work of the raters."

Issues and Complaints

Several issues are the focus of the congressional probes, each with its conclusions and rebuttals. In any case, the current politicized environment may force Congress to take action.

* How did the rating agencies miss anticipating recent corporate failures? In their testimony, the rating agencies maintain that they are dependent on the integrity of the financial reports provided by external auditors. However, the Senate staff report concluded that there was a "disappointing lack of diligence in their coverage and assessment" with regard to Enron, given their access to confidential documents and plans provided to rating agencies by companies. Still, most observers have concluded that corporate failures are difficult if not impossible to anticipate, particularly if there is intent to disguise the true nature of business transactions.

* Do adequate protections exist for investors, lenders and others who are dependent on ratings? When lawyers, accountants and physicians err, they can be disciplined by their regulators and/or by lawsuits seeking civil damages. No such relief pertains to raters, who are neither regulated or subject to legal action. For example, Colorado and California debt issuers (a school district and an HMO) sued rating agencies (Moody's and a small agency, the Weiss Group, respectively) for libel and defamation on the grounds of adverse market reaction to unsolicited opinions. However, these suits were dismissed on the grounds of an ostensibly objective rating process and the free speech protections of the First Amendment.

* Are the raters competent to do their evaluations? The special position of the NRSROs implies that analysts be adequately qualified to perform company reviews, including academic attainments (such as an MBA), professional certification (a CPA), and credit rating and industry experience. The Senate report noted that raters did not probe and consider disclosures and statements presented by Enron, and relied instead on the word of company executives. It is difficult to refute the argument that credentialing standards are appropriate in credit rating decisions, although the raters maintain that concerns for their reputation are sufficient to ensure the required level of expertise.

* Should the NRSROs disclose how their ratings are developed? A credit rating reflects a rating agency's opinion, as of a specific date, of the creditworthiness of a particular company, security or obligation. During the past three decades, the SEC and other regulators have increasingly used credit ratings to help monitor the risk of investments held by regulated entities. Ratings impact a company's access to and cost of capital, and the structure of its financial transactions. Despite the critical nature of a rating, the NRSROs have never explained (other than in the most general terms) how decisions are made, which criteria are examined and whether the process is fair and objective.

* Should the SEC ease the qualification process for the NRSRO designation? Despite the recent admission of Dominion to the "NRSRO club," the rating business has, historically, been dominated by Moody's and Standard and Poor's, with some inroads by Fitch. The NRSRO designation itself may be a barrier to entry, in that new entrants cannot be nationally recognized because companies naturally gravitate to the current group of raters. Moreover, the SEC's procedures for NRSRO recognition are lengthy and not at all clear to applicants. There seems little dispute that the designation process needs simplification to promote competition among raters; a few observers even believe that the designation should either be reconfigured or eliminated.

* Do potential conflicts of interest arise from the practice of raters being compensated by issuers? In the past decade, the NRSROs have shifted their method of compensation from investor-based to issurer-based fees. As a result, some observers believe that an inherent conflict of interest arises with companies "paying" for their ratings. There is some evidence that raters may have "pulled their punches" in situations such as Enron and WorldCom, and the NRSROs now claim that remedial actions have been taken to assure the integrity of future decisions.

Likely Outcomes

Congress and the SEC are under pressure to act, and certainly want to do so prior to any new corporate disaster. It's likely that some legislative or regulatory actions will include:

* Specification of required qualifications for ratings analysts, probably by an internal team or group, that will include accounting, financial, management and industry experience and education.

* Continuation of the NRSRO (or similar) designation, with liberalization of the rules for attainment of the designation and mandatory periodic review by the SEC and capital market participants.

* Disclosure of the procedures used by the NRSROs for developing and changing ratings. This should encourage a thoughtful review of the adequacy of a rating agency's process and stimulate innovation in the development of new approaches, including the use of models and statistical analyses.

* Development of remedies when the ratings process fails, including regulatory oversight and/or judicial review.

Conversely, there are two areas where change is less likely. First, the SEC will not require public dissemination of ratings, primarily because of the confidential nature of the relationship between the NRSROs and companies, but also because fees are paid to secure ratings. The second area involves actions to assuage possible conflicts of interest arising from payment for ratings (or the provision of such ancillary services as advice on future business plans). In this instance, the raters have their reputations at risk, and do not need additional supervision to assure their integrity.

Look for additional hearings on these issues by the fall, with new legislation or rulemaking in time for next year's presidential primaries. The SEC will almost certainly retain its administrative role, with the power of the NRSROs at least somewhat constrained.

RELATED ARTICLE: Working within the structure

Ratings allow companies to present financial and business conditions in a clear, objective manner, and regardless of any future changes to the ratings environment, companies must work closely with their raters to elicit the highest possible grade for financings. Here are some ideas to enhance that relationship:

* Meet regularly with rating agencies to review plans and expected results. There should be continuous dialog to review business developments and examine the potential credit implications of a proposed venture or of material changes in ongoing business activities. Presentations should be lively and supported by appropriate audio-visuals, and senior management attendance is mandatory to show knowledge of and support for the information that is disclosed. (Note: Reg FD [Fair Disclosure] does not apply to information provided to raters, so it does not have to be provided to the general public.)

* Expect to open up just about everything in your company to rater scrutiny. NRSROs expect access and broad exposure to an organization's operations, not merely a printout of historical financial data. Provide, a comprehensive description of your business, and allow ample opportunity for questions and discussion.

* Develop contingency plans to manage strategic or financing problems. Be able to demonstrate that you can cope with any situation, including shifts in business plans and unplanned limitations on bank financing or the commercial paper market. This involves frequent cash budgeting based on forecasts of receipts (using the distribution method) and disbursements.

James S. Sagner is a Principal of Sagner/Marks, a treasury advisory firm, and Director of the MBA program at Albertus Magnus College in New Haven, Conn. He is the author of five books on financial subjects, including The Real World of Finance (John Wiley & Sons Inc., 2002), and can be reached at 914.686.2732.