Report on the Role & Function of Credit Rating Agencies in the Operation of the Securities Markets By the SEC As Required by Section 702(b) of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission has prepared this Report on the role and function of credit rating agencies in the operation of the securities markets in response to the Congressional directive contained in the Sarbanes-Oxley Act of 2002. The Report is designed to address each of the topics identified for Commission study in the Sarbanes-Oxley Act, 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 rating agencies, barriers to entry into the credit rating business, and conflicts of interest faced by rating agencies. As the report called for by the Sarbanes-Oxley Act coincided with a review of credit rating agencies already underway at the Commission, the Report addresses certain issues regarding rating agencies, such as allegations of anticompetitive or unfair practices, the level of diligence of credit rating agencies, and the extent and manner of Commission oversight, that go beyond those specifically identified in the Sarbanes-Oxley Act. While the Commission has made significant progress in its review of credit rating agencies, and identified a wide range of issues that deserve further study, much work remains to be done. Accordingly, the Commission plans to publish a concept release within 60 days of this Report to address concerns related to credit rating agencies and expects to issue proposed rules, after reviewing and evaluating the comments received on the concept release, within a reasonable period of time after the close of the comment period. The Commission hopes to elicit extensive comments on these issues, from market participants, other regulators, and the public at large. The issues to be studied by the Commission in more depth include the following: Information Flow - whether rating agencies should disclose more information about their ratings decisions and whether there should be improvements to the extent and quality of disclosure by issuers (including disclosures relating to ratings triggers). The Commission will also look at potential conflicts of interest. That includes whether rating agencies should implement procedures to manage potential conflicts of interest that arise when issuers pay for ratings. Also, whether rating agencies should prohibit (or severely restrict) direct contacts between rating analysts and subscribers or whether rating agencies should implement procedures to manage potential conflicts of interest that arise when rating agencies develop ancillary fee-based businesses. Another area the SEC is looking at includes alleged anticompetitive or unfair practices. As well as the extent to which allegations of anticompetitive or unfair practices by large credit rating agencies have merit and, if so, possible Commission action to address them.
The Commission will also tackle reducing potential regulatory barriers for entry. This includes whether the current regulatory recognition criteria for rating agencies should be clarified or whether timing goals for the evaluation of applications for regulatory recognition should be instituted. This section will also look at whether rating agencies that cover a limited sector of the debt market, or confine their activity to a limited geographic area, should be recognized for regulatory purposes or whether there are viable alternatives to the recognition of rating agencies in Commission rules and regulations. The final section is ongoing oversight. That is whether more direct, ongoing oversight of rating agencies is warranted and, if so, the appropriate means for doing so (and whether it is advisable to ask Congress for specific legislative oversight authority). As well as whether rating agencies should incorporate general standards of diligence in performing their ratings analysis, and with respect to the training and qualifications of credit rating analysts. Introduction Section 702 of the Sarbanes-Oxley Act requires the Commission to conduct a study of the role and function of credit rating agencies in the operation of the securities markets, and to submit a report on that study to the President, the Committee on Financial Services of the House of Representatives, and the Committee on Banking, Housing, and Urban Affairs of the Senate no later than Jan. 26, 2003. This Report has been prepared in response to that requirement. A primary purpose of the Sarbanes-Oxley Act is to assure the integrity of the United States capital markets and restore investor confidence in the wake of recent financial scandals. Among other things, the Sarbanes-Oxley Act directs the Commission to examine the following: the role of credit rating agencies in the evaluation of issuers of securities; the importance of that role to investors and the functioning of the securities markets; any impediments to the accurate appraisal by credit rating agencies of the financial resources and risks of issuers of securities; any barriers to entry into the business of acting as a credit rating agency, and any measures needed to remove such barriers; any measures which may be required to improve the dissemination of information concerning such resources and risks when credit rating agencies announce credit ratings; and any conflicts of interest in the operation of credit rating agencies and measures to prevent such conflicts or ameliorate the consequences of such conflicts. Congress itself also has been reviewing issues relating to credit rating agencies. In March 2002, for example, the Senate Committee on Governmental Affairs held hearings to determine how the credit rating agencies could have rated Enron Corporation as a good credit risk until just four days before the company declared bankruptcy. In October 2002, the staff of the Senate Committee issued a report containing the results of its investigation into, among other things, the actions of certain credit rating agencies that monitored the financial activities of Enron in the years prior to its collapse. The Staff Report concluded that, in the case of Enron, the credit rating agencies displayed a disappointing lack of diligence in their coverage and assessment of that company. In
addition, the Staff Report found that, because the credit rating agencies are subject to little formal regulation or oversight, and their liability traditionally has been limited by regulatory exemptions and First Amendment protections, there is little to hold them accountable for future poor performance. As a result, the Staff Report recommended that the Commission, among other things, require recognized rating agencies to comply with specified performance and training standards and regularly monitor their compliance with those standards. The issues reviewed in the Staff Report, as well as the study required by the Sarbanes-Oxley Act, are consistent with recent Commission initiatives to review the role of rating agencies in the U.S. securities markets and their regulatory treatment. The Commission recognized that, in recent years, the importance of credit ratings to investors and other market participants had increased significantly, impacting an issuer’s access to and cost of capital, the structure of financial transactions, and the ability of fiduciaries and others to make particular investments. In light of this increased importance, the Commission had commenced a review of the use of credit ratings in federal securities laws, the process of determining which credit ratings should be used for regulatory purposes, and the level of oversight to apply to recognized rating agencies. The Commission pursued several approaches, both formal and informal, to conduct a thorough and meaningful study of credit rating agencies. These efforts included informal discussions with credit rating agencies and market participants, formal examinations of credit rating agencies, and public hearings, where market participants were given the opportunity to offer their views on credit rating agencies and their role in the capital markets. To read the full report, click here.