Mr. Arthur LevittChairmanSecurities and Exchange Commission450 Fifth Street, N.W.Washington, DC 20549
Dear Chairman Levitt:
On behalf of the American Antitrust Institute (AAI), I offer these comments with respect to File No. S7-33-97, which concerns a proposed amendment to Rule 15c3-1 under the Securities Exchange Act of 1934 (Release No. 34-39457). The proposed amendment would define the term "nationally recognized statistical rating organization" (NRSRO). Though the Securities and Exchange Commission (SEC) proposed this amendment on December 17, 1997, the SEC has taken no action since then to transform its proposed rule into a final regulation. The SEC's inaction on this regulation, as well as the content of the proposed rule in its current form, represents a serious impediment to entry by and expanded competition among credit rating firms.
The AAI strongly urges the SEC to remove this impediment by reformulating and reintroducing its proposed rule in the ways suggested below, so as to encourage more entry by and greater competition among credit rating firms.
In addition to the specific comments that I have provided below, I have attached a longer study of the credit rating industry that extends and amplifies many of the points that I make in this letter.
The American Antitrust Institute
The American Antitrust Institute is an independent, non-profit education, research and advocacy organization, whose background and prior work products may be found on the Internet at www.antitrustinstitute.org. Since its founding in 1998, the AAI has regularly testified and presented public comments and commentaries on competition policy issues involving both regulated and unregulated industries. The AAI favors market-oriented policies that will enhance competition through the active use of antitrust approaches.
The Advisory Board of the AAI includes 55 lawyers, economists, and business experts who are consulted on the activities that the AAI undertakes, but who do not vote. The author of this letter is a member of the AAI Advisory Board. I have attached a brief summary of my academic and professional credentials.
Background on the Proposed Rule
The SEC created the NRSRO term in 1975, as part of the Commission's net capital rule for broker-dealers, Rule 15c3-1. That net capital rule allows for smaller discounts ("haircuts") on securities owned by broker-dealers, when calculating their net capital, if the securities are rated as investment grade by at least two credit rating firms. The SEC apparently realized at the time that if it was going to create standards that called for credit ratings, it would have to specify whose credit ratings would qualify. Without such designation, bogus rating firms could be created whose sole purpose was indiscriminately to dispense favorable ratings. Hence the NRSRO category was created.
Since 1975 the use of the NRSRO concept has widened considerably, as the Congress and other regulatory agencies -- as well as the SEC itself -- have expanded the regulatory areas in which credit ratings are used as indicators of safety. But the SEC has never formally defined the term NRSRO. Nevertheless, at the time of the NRSRO concept's inception the SEC "grandfathered" three incumbents as NRSROs and subsequently granted the designation to a few more rating firms.
The criteria that the SEC staff has used in granting these designations -- through "no-action" letters -- would be incorporated into Rule 15c3-1 by the proposed amendment. I will defer further comment on these criteria to the discussion below.
The pattern of these actions is important to note, however. The SEC initially "grandfathered" three NRSROs: Moody's, Standard & Poors, and Fitch. It subsequently designated Duff & Phelps (1982) and McCarthy, Crisanti & Maffei (MCM) (1983) as NRSROs (MCM was absorbed by Duff & Phelps in 1991), and designated IBCA (1991) and Thomson BankWatch (1992) as specialized NRSROs for banks and financial institutions. In November 1997 Fitch merged with IBCA, and the merged entity retained Fitch's general-purpose NRSRO designation. In January 1999 the SEC "upgraded" Thomson BankWatch's status from a specialized NRSRO to a general-purpose NRSRO. (In June 2000 Fitch IBCA bought Duff & Phelps; in December 2000 Thomson BankWatch was absorbed by Fitch IBCA.)
The SEC has not granted the general-purpose NRSRO designation to any new entity since 1983, and it has not granted specialized NRSRO status to any new entity since 1992. With the recent mergers and absorptions just noted, the number of NRSROs stands at only three.
In its decisions concerning NRSRO designations the SEC staff has used a set of criteria that would now be formally embodied in the proposed regulations. It is to those criteria that I now turn.
The SEC's Proposed Criteria
The attributes of a rating firm that the SEC proposes to use as its criteria for designating NRSROs are as follows (the following language is taken directly from the proposed rule):
1) national recognition, which means that the rating organization is recognized as an issuer of credible and reliable ratings by the predominant users of securities ratings in the United States;
2) adequate staffing, financial resources, and organizational structure to ensure that it can issue credible and reliable ratings of the debt of issuers, including the ability to operate independently of economic pressures or control by companies it rates and a sufficient number of staff members qualified in terms of education and expertise to thoroughly and competently evaluate an issuer's credit;
3) use of systematic rating procedures that are designed to ensure credible and accurate ratings;
4) extent of contacts with the management of issuers, including access to senior level management of the issuers; and
5) internal procedures to prevent misuse of non-public information and compliance with these procedures.
A Critique of the Proposed Criteria
The SEC is to be commended for recognizing that, if ratings are going to be used for safety-and-soundness regulatory purposes, someone has to decide whose ratings shall qualify; and it is also to be commended for proposing to replace two decades' of informal NRSRO designation criteria with a set of formal criteria.
Since the need to certify NRSROs rests on the regulators' delegation of safety decisions to the rating firms and on the possibility that bogus rating firms could indiscriminately distribute favorable ratings, the SEC should make judgments about the accuracy/efficacy/competency of a rating firm with respect to the relevant safety issues. Since the rating firms focus on the likelihood of default with respect to specific securities and the safety-and-soundness regulators appear to be satisfied in relying on those judgments, the SEC should assess a rating firm's performance in this regard. Another way of stating this proposition is that the SEC must judge the outputs of the rating firms.
Unfortunately, against this standard, the criteria that the SEC has proposed are seriously deficient. The first criterion ("national recognition") might appear to be an indirect market test of performance: if a rating firm was not performing well, it might cease to retain a national following. But in the current context of only three incumbent NRSROs and a substantial regulation-driven demand for those firms' rating services, a national following for the current incumbents is all but guaranteed; and the task of a new or small rating firm to attract national recognition is made substantially harder than it otherwise would be by its lack of a NRSRO designation while three incumbents have NRSRO designations. If a company executive has to decide which rating firm(s) to spend time telling his/her company's financial "story" to, it seems highly likely that the executive will choose an incumbent NRSRO -- whose favorable rating can qualify the company's securities for favorable regulatory treatment -- over any non-NRSRO.
Further, foreign credit rating firms may have substantial expertise abroad; but their lack of U.S. "national recognition" dooms their prospects for NRSRO designation.
In essence, the "national recognition" criterion creates a "Catch 22" barrier to entry.
The remaining four criteria (adequate resources; systematic procedures; adequate contacts; internal procedures) are measures of inputs, not output. Smaller firms or firms with innovative rating technologies will be at a disadvantage if judged by these criteria.
The immediate consequence of the adoption of the SEC's proposed criteria would be a continuation of the current three-firm NRSRO industry. A "triopoly" that is protected by high regulatory barriers to entry is highly unlikely to exhibit full competitive vigor. This unfortunate conclusion is strengthened by the safety-and-soundness regulatory demands for ratings, which often require that an issuer receive favorable ratings from at least two NRSROs.
Some Superior, Pro-Competitive Alternatives
For the immediate future, the SEC must be prepared to establish formal criteria and certify suitably qualified NRSROs. But, for the reasons explained above, the SEC's proposed criteria are likely simply to perpetuate the anti-competitive status quo.
Instead, the SEC must make a serious effort to specify criteria for the designation of NRSROs in ways that do not create artificial barriers to entry and impediments to competition. As was stated above, the SEC must be prepared to make judgments about the accuracy/efficacy/competency of a rating firm with respect to the relevant safety issues. Since the rating firms focus on the likelihood of default with respect to specific securities and the safety-and-soundness regulators appear to be satisfied in relying on those judgments, the SEC must be prepared to assess a rating firm's performance in this regard. The SEC's criteria must be refocused to these output considerations, rather than focusing on inputs and on already existing national recognition.
In its efforts to ascertain the accuracy/efficacy/competency of a prospective NRSRO, the SEC ought to be able to make use of market judgments to assist its assessment. Since the participants in the financial markets surely care about the accuracy of a rating firm's ratings, if a rating firm has been able to attract a market following, this should certainly be considered as a positive attribute in the SEC's assessment of a candidate for a NRSRO designation. But, again, a requirement that a prospective NRSRO designee already have national market recognition is far too stringent and will ossify the industry in its current three-firm structure.
Further, the SEC should move quickly to refocus and repropose its criteria. Under current circumstances, delay means the continuation of the existing barriers to entry and impediments to competition. As a way of speeding this process, the SEC staff could reformulate the criteria that it uses for its no action letters to incorporate these output/performance considerations.
Over the longer run, the best way for the SEC to extricate itself from the difficulties of designating NRSROs would be for the SEC to eliminate the category. To do this, the SEC and other regulatory agencies would have to be willing to specify directly the safety criteria that they are seeking in securities, rather than delegating that task to rating firms. Though the SEC does not have the power directly to make these decisions for other regulatory agencies, it could take the lead by initiating a rulemaking in which it would propose to specify the safety criteria and simultaneously propose to eliminate the NRSRO category. Such actions might inspire the other safety-and-soundness regulators similarly to specify their safety requirements directly.
Without the NRSRO category and without the rating delegations by other regulators, the participants in the financial markets, on their own, would decide whether and which rating firms provide enough help in piercing the asymmetric information fog of these markets so as to justify the firms' costs and fees. The rating firms' fates -- incumbent and entrant alike -- would be left to the financial markets, where they belong.
The SEC is to be commended for its willingness to specify its criteria for NRSROs formally. But its past pattern of severely limited designations of NRSRO status has created a major barrier to entry into the credit rating industry and has surely impaired competition. The SEC's proposed criteria would codify and fortify that anti-competitive barrier to entry.
I strongly urge the SEC to refocus and repropose its NRSRO criteria along the lines suggested in this letter and similarly to refocus its no-action letter criteria for granting NRSRO status in the interim.
Lawrence J. White