For other versions of this document, see http://wikileaks.org/wiki/CRS-RL33651 ------------------------------------------------------------------------------ Order Code RL33651 CRS Report for Congress Received through the CRS Web Credit Rating Agency Regulatory Reform: A Side-by-Side Comparison of H.R. 2990 and S. 3850 September 19, 2006 Gary Shorter Specialist in Business and Government Relations Government and Finance Division Congressional Research Service ~ The Library of Congress Credit Rating Agency Regulatory Reform: A Side-by-Side Comparison of H.R. 2990 and S. 3850 Summary Credit rating agencies assess the probability that a securities issuer will default by failing to repay principal and interest on the security. Globally, there are about 130 agencies, but Moody's and Standard & Poor's (S&P) combine for about 80% of overall market share, with Fitch accounting for about a 15% share. In 1975, the Securities and Exchange Commission (SEC) issued the Net Capital Rule, which set new capital requirements for broker-dealers and required them to take a larger discount on their bond holdings deemed to be below investment grade by a rating agency that it recognized as a nationally recognized statistical rating organization (NRSRO). Since then, a growing number of federal, state, and foreign government statutes and regulations have adopted NRSRO ratings as reference points or triggers. However, there is no statutory definition of an NRSRO. When a rating agency requests NRSRO status, it applies to the SEC Division of Market Regulation for NRSRO designation, a decision-making process that is often both uncertain and of an indefinite time span. Currently, five rating agencies have NRSRO designation: Fitch; Moody's; S&P; the A.M. Best Company, which rates insurance and reinsurance firms; and the Dominion Bond Rating Service Limited, a Canadian-based firm. Like other providers of financial market analysis, the major NRSROs play a critical role as financial sentries or gatekeepers whose assessments can help warn against corporate meltdowns. Their record, however, is imperfect. For example, in 2001, Moody's, S&P, and Fitch issued favorable credit ratings of WorldCom bonds three months before the company declared bankruptcy. Additional concerns exist over the way in which the NRSRO process may impede non-NRSROs' access to more profitable segments of the rating industry. In the 109th Congress, two legislative responses to the perceived shortcomings of the NRSRO protocol are H.R. 2990 (Fitzpatrick), the Credit Rating Agency Duopoly Relief Act of 2006, which passed the House on July 12, 2006, and S. 3850 (Shelby), the Credit Rating Agency Reform Act of 2006, which was voted out of the Senate Banking and Urban Affairs Committee on August 2, 2006. Both bills would scrap the current NRSRO designation process and instead would allow entities with at least three consecutive years as rating agencies to register with the SEC as NRSROs. S. 3850 would permit the SEC to reject a rating agency's application for NRSRO registration if it determined that the rater lacked sufficient financial and managerial resources, whereas H.R. 2990 would impose no such test. Each bill, if enacted, would be likely to significantly expand the number of NRSROs. This report provides a side-by-side comparison of the bills' major provisions; it will be updated as events dictate. Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 List of Tables Table 1. A Comparison of Major Provisions of H.R. 2990 and S. 3850 . . . . . . . 3 Credit Rating Agency Regulatory Reform: A Side-by-Side Comparison of H.R. 2990 and S. 3850 Introduction Credit rating agencies assess the probability that a securities issuer will default by failing to repay principal and interest on the security. Two rating agencies dominate the rating industry -- Moody's and Standard & Poor's (S&P) who combine for about 80% of the overall market share. Fitch Ratings has about a 15% share. Globally, there are about 130 agencies. In 1975, the Securities and Exchange Commission (SEC) issued the Net Capital Rule, which set new capital requirements for broker-dealers and required them to take a larger discount on their bond holdings deemed to be below investment grade by a rating agency that it recognized as a nationally recognized statistical rating organization (NRSRO). Since then, a growing number of federal, state, and foreign government statutes and regulations have adopted NRSRO ratings as reference points or triggers. But there is no statutory definition of an NRSRO. When a rating agency requests NRSRO status, it applies to the SEC Division of Market Regulation for NRSRO designation. And through what is known as the no-action letter process,1 the division can take an indefinite amount of time to determine whether to grant the designation, a decision that is significantly based on whether the applicant is a nationally recognized issuer of credible ratings. Currently, five rating agencies have NRSRO designations: Fitch; Moody's; S&P; the A.M. Best Company, which rates insurance and reinsurance firms and received NRSRO status in 2005; and the Dominion Bond Rating Service Limited, a Canadian-based firm that was granted NRSRO status in 2003. In addition to other sources of financial market analysis like securities analysts, the major NRSROs also play a critical role as financial sentries or gatekeepers whose assessments can help warn against corporate meltdowns. Their record, however, is imperfect. In 2001, Moody's, S&P, and Fitch issued favorable credit ratings of WorldCom bonds three months before the company declared bankruptcy. Moody's and S&P provided favorable bond ratings for Enron corporate bonds just before the firm's bankruptcy. The collapse of these firms eventually cost investors billions of 1 A no-action letter is an SEC communication stipulating that the agency does not object to a course of action proposed by a registrant. They are generally issued after an applicant has made a request. CRS-2 dollars and provoked widespread criticism of the agencies both in and out of Congress. These concerns, to which the NRSROs respond that they were themselves the victims of corporate deceit, exist alongside criticism that the NRSRO selection process is an anticompetitive mechanism that impedes non-NRSROs' access to the more profitable segments of the rating industry. The congressional response to the perceived problems surrounding the NRSRO process and its potentially undesirable consequences has led to the introduction of two bills in the 109th Congress. H.R. 2990 (Fitzpatrick), the Credit Rating Agency Duopoly Relief Act of 2006, passed the House on July 12, 2006, in a vote closely divided along partisan lines. Soon afterwards, on August 2, S. 3850 (Shelby), the Credit Rating Agency Reform Act of 2006, was voted out of the Senate Banking and Urban Affairs Committee with significant bipartisan support. Both bills would scrap the SEC's current no-action-letter-based NRSRO designation process with its central focus on whether an agency is nationally recognized as an issuer of credible ratings, and with its indefinite decision making time frames. Both would amend the Securities Exchange Act of 1934 to allow interested entities with at least three consecutive years as rating agencies to register with the SEC as NRSROs, which would involve the submission of performance measurement statistics, a description of their rating methodology, details of ethics policies, and disclosure of conflicts of interest. Under both bills, once the SEC received a credit agency's application to register as an NRSRO, it would have up to 120 days -- with the possibility of an extension if deemed necessary -- to determine whether to deny or grant the registration. S. 3850 would allow the SEC to reject a rating agency's application for NRSRO registration if it determined the applicant lacked sufficient financial and managerial resources. H.R. 2990 has no such requirement. S. 3850 would require NRSRO applicants to provide written certifications from at least 10 of their institutional customers to the SEC. Applicants would also have to provide a list of their 20 largest issuers and subscribers by the amount of net revenues received in the previous year. Neither provision is part of H.R. 2990. S. 3850 would also direct the SEC to issue rules on NRSRO conflicts of interest and the misuse of non-public information conflicts of interest, provisions that are absent from H.R. 2990. Either bill, if enacted, would be likely to significantly expand the number of NRSROs from the current five. This report compares the major provisions of the two legislative proposals. Key differences between the two bills have been italicized. CRS-3 Table 1. A Comparison of Major Provisions of H.R. 2990 and S. 3850 Provision H.R. 2990 S. 3850 Cessation of the SEC's Within 30 days after the Upon a designated effective current No-Action Letter- legislation's enactment, the date, an entity that previously based NRSRO designation SEC shall cease to designate relied on the SEC's no-action process persons and companies as letter for its NRSRO status NRSROs as it currently may continue to use the under rule 15c3-1 of the designation if it has filed an agency's rules (17 CFR application for NRSRO 240.15c3-1). In addition, the registration that has been SEC's current no-action approved by the SEC. process for NRSRO (Section 4) designation would be voided. (Section 4) Defining a credit rating A credit agency is defined as A credit agency is defined as agency an entity that is engaged in an entity that is engaged in the business of issuing credit the business of issuing credit ratings on the Internet or ratings on the Internet or through another readily through another readily accessible means, for free or accessible means, for free or for a reasonable fee that for a reasonable fee that employs either a quantitative employs either a quantitative or qualitativea model, or both, or qualitative model; or both, and receives fees from either and receives fees from either issuers, investors, or other issuers, investors, or other market participants. market participants. (Section 3) (Section 3) Credit rating agency To register as an NRSRO To register as an NRSRO experience needed to with the SEC, a credit rating with the SEC: (1) a credit qualify for registration as agency must have been in rating agency must have been an NRSRO business for at least three in business for at least three consecutive years. consecutive years; and (2) (Section 3) have received written certifications from at least 10 "qualified institutional buyers" (as defined in section 230.144 (a) of title 17, Code of Federal Regulations). (Section 3) CRS-4 Provision H.R. 2990 S. 3850 What the SEC is authorized The SEC is authorized to The SEC is authorized to to require of credit rating require a credit rating agency require a credit rating agency agencies interested in that elects to be registered as that elects to be registered as registering as NRSROs an NRSRO to file an NRSRO to file information that may include information that may include (1) any conflicts of interest (1) any conflicts of interest relating to the issuance of relating to the issuance of credit ratings; (2) the credit ratings; (2) the procedures and procedures and methodologies used in methodologies used in determining credit ratings; (3) determining credit ratings; (3) their credit ratings their credit ratings performance measurement performance measurement statistics over short-term, statistics over short-term, mid-term, and long-term mid-term, and long-term periods; (4) policies or periods; (4) policies or procedures adopted and procedures adopted and implemented to prevent the implemented to prevent the misuse of material, misuse of material, non-public information; and non-public information; (5) (5) its organizational its organizational structure; structure. (Section 4) (6) a confidential list of the 20 largest issuers and subscribers by the amount of net revenues received in the fiscal year prior to the application date; and (7) written certifications from at least 10 "qualified institutional buyers" who have used the applicant's ratings. (Section 4) The SEC's review of an Within 90 days after an Within 90 days after an NRSRO application applicant has filed for applicant has filed for registration, the SEC shall registration, the SEC shall either grant NRSRO either grant NRSRO registration or begin registration or begin proceedings to determine proceedings to determine whether registration should whether registration should be denied. The proceedings be denied. The proceedings shall end within 120 days shall end within 120 days from the date that the from the date that the application was furnished and application was received and shall involve a determination shall involve a determination by the SEC on whether the by the SEC on whether the applicant is granted or denied applicant is granted or denied NRSRO registration. If the NRSRO registration. If the agency finds sufficient cause agency finds sufficient cause for an extension, it may for an extension, it may extend the NRSRO extend the NRSRO registration proceeding for up registration proceeding for up to 90 additional days. to 90 additional days, or for (Section 4) longer periods with the applicant's consent. (Section 4) CRS-5 Provision H.R. 2990 S. 3850 Grounds for the SEC's The SEC shall grant NRSRO The SEC shall grant NRSRO decision to approve an registration if it finds that the registration if it finds that the applicant's registration as requirements of the preceding requirements of the preceding an NRSRO section are satisfied. It shall section are satisfied. The deny the registration if it does agency shall deny not make such a finding. In registration if it finds that the the event that the applicant is applicant does not have already registered, that adequate financial and registration would be subject managerial resources to to suspension or revocation. consistently produce ratings (Section 4) with integrity and that comply with its procedures and methodology (as dis- closed above). In the event that the applicant is already registered, that registration would be subject to suspension or revocation. (Section 4) Requirements for updating Generally, credit agencies Generally, credit agencies an applicant's information that have gained NRSO that have gained NRSO registration would be registration would be required to promptly amend required to promptly amend their applications with the their applications with the SEC if developments have SEC if developments have rendered previous disclosures rendered previous disclosures to be materially inaccurate. to be materially inaccurate. And not later than 90 days And not later than 90 days after the end of each calendar after the end of each calendar year, they would also have to year, they would also have to file registration amendments file registration amendments with the agency, certifying with the agency, certifying the accuracy of their the accuracy of their disclosures and identifying disclosures and identifying any material changes since any material changes since the previous year's filings. the previous year's filings. (Section 4) (Section 4) CRS-6 Provision H.R. 2990 S. 3850 The elements of the SEC's The SEC would have the The SEC would have the authority to enforce authority to take action authority to take action NRSRO accountability against NRSROs who violate against NRSROs who violate the procedures, criteria, and the procedures, criteria, and methodologies contained in methodologies contained in registration applications. It registration applications. It also would authorize the also would authorize the agency to censure, place agency to censure, place limitations on the activities, limitations on the activities, functions, or operations of, functions, or operations of, suspend for a period not suspend for a period not exceeding 12 months, or exceeding 12 months, or revoke the registration of any revoke the registration of any NRSRO or person associated NRSRO or person associated with an NRSRO has been with an NRSRO has been found to: a) have been in found to: a) have been in violation of certain federal violation of certain federal laws; b) have been convicted laws; b) have been convicted during the 10-year period during the 10-year period preceding the date of preceding the date of furnishing the NRSRO furnishing the NRSRO application; and c) have been application; c) have been punished for any crime that is punished for any crime that is punishable by imprisonment punishable by imprisonment for a period of one or more for a period of one or more years, or a substantially years, or a substantially equivalent crime by a foreign equivalent crime by a foreign court. (Section 4) court; and d) have failed to file the required certifications or to maintain adequate financial and managerial resources to consistently produce credit ratings with integrity. (Section 4) Limitations on the SEC's None of the legislation's rules None of the legislation's rules authority over NRSROs on the SEC's authority over on the SEC's authority over the NRSRO registration the NRSRO registration process shall be interpreted to process shall be interpreted to give the agency the authority give the agency the authority to regulate the substance of to regulate the substance of credit ratings or the credit ratings or the procedures and procedures and methodologies by which methodologies by which NRSROs determine ratings. NRSROs determine ratings. Public availability of Generally, upon being Generally, upon being information NRSROs registered as an NRSRO by registered as an NRSRO by submit to the SEC the SEC, a credit rating the SEC, a credit rating agency must make the agency must make the information and documents it information and documents it furnished to the agency as furnished to the agency as part of the registration part of the registration process publicly available process publicly available through either its website or through either its website or an alternative readily an alternative readily accessible means. accessible means. CRS-7 Provision H.R. 2990 S. 3850 SEC adoption of rules to The SEC shall adopt rules or The SEC shall adopt rules or prevent misuse of nonpublic regulations to require policies regulations to require policies information or procedures designed to or procedures designed to prevent NRSROs from the prevent NRSROs from the misuse of the material, misuse of the material, nonpublic information that nonpublic information that they collect. (Section 4) they collect. (Section 4) SEC adoption of rules for The SEC, as it deems The SEC shall issue rules to the prevention of conflicts necessary or appropriate, prohibit, or require the of interest shall adopt rules or management and disclosure regulations to prohibit, or of, any conflicts of interest require the management or relating to the issuance of disclosure of, any conflicts of ratings by an NRSRO that interest relating to the shall include (1) the manner issuance of ratings by an of an NRSRO's NRSRO that shall include (1) compensation for ratings or the manner of an NRSRO's related services; (2) the compensation for ratings or consulting, advisory, or other related services; (2) the services provided by an consulting, advisory, or other NRSRO; (3) the nature of the services provided by an business ties, ownership NRSRO; (3) the nature of the interests, or other financial or business ties, ownership personal associations between interests, or other financial or an NRSRO and entities who personal associations between do business with it; (4) an NRSRO and entities who affiliations between an do business with it; and (4) NRSRO and entities that affiliations between an underwrite the securities or NRSRO and entities that money market instruments underwrite the securities or rated by the NRSRO; and (5) money market instruments any other potential conflicts rated by the NRSRO. of interest that the SEC (Section 4) deems necessary for the public interest or for the protection of investors. (Section 4) CRS-8 Provision H.R. 2990 S. 3850 SEC adoption of rules for The SEC may adopt rules or The SEC may adopt rules or the prevention of regulations relating to regulations relating to prohibited acts and NRSROs: (1) seeking NRSROs : (1) seeking practices payment for a credit rating payment for a credit rating that has not been specifically that has not been specifically requested by the issuer (an requested by the issuer (an unsolicited rating); (2) unsolicited rating); (2) conditioning or threatening conditioning or threatening to condition the issuance of a to condition the issuance of a credit rating on the issuer's credit rating on the issuer's purchase of other services or purchase of other services or products; (3) lowering or products; (3) lowering or threatening to lower a credit threatening to lower a credit rating on, or refusing to rate, rating on, or refusing to rate, securities or money market securities or money market instruments issued by an asset instruments issued by an asset pool unless a portion of the pool unless a portion of the assets within such pool also is assets within such pool also is rated by the NRSRO; and (4) rated by the NRSRO; and (4) modifying or threatening to modifying or threatening to modify a credit rating or modify a credit rating or otherwise departing from its otherwise departing from its standard methodologies for standard methodologies for determining credit ratings, determining credit ratings, based on whether an issuer based on whether an issuer pays or will pay for the credit pays or will pay for the credit rating or any other of the rating or any other of the NRSRO's services or NRSRO's services or products. (Section 4) products. (Section 4) NRSRO requirements for Each NRSO shall designate a Each NRSO shall designate a compliance officers and compliance officer with compliance officer with financial condition data responsibility for ensuring responsibility for ensuring compliance with the compliance with the securities laws. securities laws. In addition, the SEC is given In addition, the SEC is given the authority to require the authority to require NRSROs to provide it with NRSROs to provide it with confidential, independently confidential, independently audited financial statements audited financial statements on their financial conditions, on their financial conditions, the specific nature of the the specific nature of the filings and the interval filings and the interval between such filings to be between such filings to be determined by the agency. determined by the agency. (Section 4) (Section 4) Notice to other agencies of Within 30 days after the date Within 30 days after the date the changes in the of enactment, the SEC shall of enactment, the SEC shall treatment of the term notify federal agencies whose notify federal agencies whose NRSRO rules or regulations use the rules or regulations use the term "nationally recognized term "nationally recognized statistical rating organization" statistical rating organization" of the law's changes in the of the law's changes in the treatment of the term. treatment of the term. (Section 4) (Section 4) CRS-9 Provision H.R. 2990 S. 3850 No waiver of right of action None NRSRO registration does not and no creation of a private constitute a waiver of any right of action right that the NRSRO might otherwise have under state or federal law. No reports provided by an NRSRO shall create a private right of action. (Section 4) Review of existing Within 360 days after the Within 270 days after the regulations date of enactment, the SEC date of enactment, the SEC shall review its existing rules shall review its existing rules and regulations that employ and regulations that employ the term "nationally the term "nationally recognized statistical rating recognized statistical rating organization" or "NRSRO" organization" or "NRSRO" and promulgate new or and amend or revise such revised rules and regulations rules in accordance with the as it deems necessary for goals of this law as it deems either the public interest or necessary for either the public the protection of investors. interest or the protection of (Section 4) investors. (Section 4) Conforming amendments Provides for conforming Provides for conforming amendments to several amendments to several Federal statutes, including the Federal statutes, including the Securities Exchange Act of Securities Exchange Act of 1934, the Investment 1934, the Investment Company Act of 1940, the Company Act of 1940, the Investment Advisers Act of Investment Advisers Act of 1940, and the Housing and 1940, and the Housing and Community Development Act Community Development Act of 1992. of 1992. a. In the qualitative approach information is gleaned from analysts' trips to the rated firm. In the quantitative approach information is gleaned from the rated firm's publicly available financial statements. ------------------------------------------------------------------------------ For other versions of this document, see http://wikileaks.org/wiki/CRS-RL33651