Why FEI supports credit rating agency reform.

Credit rating agencies (CRAs) play a vital role in the U.S. and world financial markets. Unfortunately, the current credit marketplace suffers from three obvious shortcomings that Congress has expressed an interest in addressing: a lack of real competition, a lack of accountability and the presence of conflicts of interest.

FEI's Committee on Corporate Finance (CCF) has worked closely with the House Financial Services Committee and the Senate Banking Committee to tackle these concerns legislatively. The House is currently considering H.R. 2990, the "Credit Rating Agency Duopoly Relief Act of 2005," which would establish new registration procedures designed to increase competition in the credit rating marketplace. Likewise, the Senate Banking Committee recently held hearings on credit rating agency oversight and operations. FEI President Colleen Cunningham testified at the hearing, and reiterated the call for greater competition and accountability in the rating marketplace.

What specific concerns has CCF raised? To begin with, there are more than 100 CRAs operating worldwide, but only five are designated as Nationally Recognized Statistical Rating Organizations (NRSROs) by the Securities and Exchange Commission (SEC). These five enjoy a competitive advantage over their peers because the guidelines for many government, mutual fund and other institutional investment portfolios not only specify minimum credit ratings for their securities but also require that the ratings come from NRSROs. The scarcity of NRSROs and the ambiguity surrounding the designation criteria have left these incumbents with a distinct competitive edge.

The most effective way to increase competition in the credit rating market would be to eliminate the broken "no action" process the SEC uses to recognize NRSROs, and to replace it with transparent registration requirements. By establishing clear criteria for registration, Congress would not only ensure the continued validity of ratings issued by "registered" credit rating agencies, but would also generate more competition. That, in turn, would provide more choice for issuers and lower costs for rating services.

Another problem with the current system is that there is no mechanism in place to ensure that NRSROs continue to satisfy the criteria necessary to maintain their designation. Once a rating agency has earned an NRSRO designation, it is required to notify the SEC only when it experiences material changes that may affect its ability to meet any of these criteria. Given the enormous financial impact that a loss of a designation would have, it is unrealistic to expect NRSROs to police themselves. For this reason, Congress should require regular performance audits to ensure that registered CRAs continue to satisfy these criteria.

Added Information Is Needed

In addition to these performance audits, CRAs should be required to disclose additional information about their operations as part of their registration application with the SEC. These disclosures could address such items as the CRAs' policies and procedures for protecting non-public information and for handling conflicts of interest; the training and experience of those individuals tasked with developing ratings; and the involvement of a CRA's staff with an issuer's management prior to developing its ratings. This information would help investors differentiate among registered CRAs, and might help issuers decide which CRA to retain for rating purposes.

Yet another flaw in the current system is that it fails to address the important issue of conflicts of interest. For example, some NRSROs have sold fee-based advisory services to their rated clients in areas such as risk management, corporate governance and data analysis. These NRSROs have assured policymakers that they have erected adequate firewalls between their rating service and advisory service operations. While this may be the case, issuers may nevertheless feel pressure to purchase advisory services to enhance the likelihood of receiving a good credit rating. In a recent FEI survey, fully 25 percent of respondents said they were actively "encouraged" to buy such services.

A bright-line rule, similar to the restrictions included in Title II of the Sarbanes-Oxley Act, would solve this problem. Title II addressed the issue of auditor independence, and enumerated specific activities that registered public accounting firms could no longer perform for audit clients. A similar line should be drawn here: Rating agencies should not be allowed to provide both fee-based advisory services and rating services to the same issuer. This bifurcation of ratings and advisory services should help ensure that credit ratings are developed and disseminated based solely on a companies' creditworthiness.

The SEC has suggested that it lacks the statutory authority to oversee the work of the credit rating agencies. Consequently, CCF has urged Congress to introduce legislation that addresses the concerns raised above. H.R. 2990 is a good start. CCF hopes the Senate will consider companion legislation sometime this year.

Mark Prysock ([e-mail]) is FEI's Director of Public Affairs and General Counsel in the Washington, D.C., office.