VideoSean Egan does not mince words. In letters to Congress and in interviews, the president of credit-rating agency Egan-Jones Ratings Co. compares his competition to "thugs" and "criminals." In a formal filing with the Securities and Exchange Commission, he argues that reforms aimed at Standard and Poor's, Moody's Investors Service, and Fitch are as pointless as requiring a mugger to explain himself to his victims. "It does not offset his robbing you."
"My language is harsh," concedes Egan, "but we don't see any way around the problems [with rating agencies] without going to the root cause" — by which he means the fact that most rating agencies are paid by the companies they rate rather than by the investors who use the ratings.
Egan has an ax to grind: his small, 14-analyst firm lacks the coveted NRSRO (nationally recognized statistical rating organization) status the government bestowed on S&P, Moody's, and Fitch. Those firms, despite greater resources and hundreds of analysts, hesitated to downgrade Enron and WorldCom until the collapse of those companies was almost a certainty. Egan-Jones, which is funded by investor subscription, dropped Enron below investment grade a month before it collapsed, and rated WorldCom as junk for almost a year before it went bankrupt.
Today the NRSROs are facing the same intense regulatory review that forced enormous changes on the accounting and investment-banking industries. A U.S. Senate committee report concluded that "the rating agencies' approach to Enron fell short of what the public had a right to expect."
But despite apparent parallels with audit firms and the investment banks, it is not clear exactly what the large rating agencies did wrong. True, they missed some major corporate meltdowns, but were they corrupt, incompetent, or simply cautious? "[There's] no smoking gun," S&P president Leo O'Neill told CFO in an interview earlier this year (see "Credit Watch," January). "All the scrutiny and review for the last 15 to 16 months have revealed absolutely no wrongdoing by Moody's or any credit-rating agency," adds Moody's president Ray McDaniel, "which is unique among all the sectors that have been investigated by authorities over the last few months."
Even the SEC doesn't seem to know exactly what problem it is trying to fix. As a result, it's far from clear what actions it will take to shore up investor confidence in ratings, or how its actions will affect the rating agencies' relationships with companies. Egan is not sanguine about the outcome: "What will probably come out of this is the recognition of some additional NRSROs, and then a continuation of business as it has been conducted over the past 25 years."
A Fine Distinction
The NRSRO designation consumes much of the debate over what, if anything, to do. Back in 1975, the SEC required securities dealers to evaluate their risk using ratings, and specified some acceptable ratings providers, or NRSROs. The unintended result of this move was a government-sanctioned — and unregulated — oligopoly of S&P, Moody's, and Fitch.
Critics say this designation has become a barrier to entry into the rating business. There's no formal definition of what an NRSRO should be (it was, after all, meant to describe existing firms) and no official process for becoming one, although the SEC occasionally names new NRSROs. Dominion Bond Rating Service was given the status in February. Egan-Jones, on the other hand, has been waiting five years for a nod.
SEC commissioners are reportedly split over whether they should address the perceived failures of rating agencies by regulating NRSROs or simply by eliminating the designation (thereby opening up the business to broader competition).
Either move is problematic. The NRSRO term has become so enshrined in banking and securities regulations that doing away with it would be an enormous legislative headache, and could destabilize other investor protections. In addition to the SEC's regulation of net capital requirements for broker-dealers, some eight federal statutes, 47 federal regulations, and more than 100 state laws and regulations rely on NRSRO ratings. And that's not counting thousands of private contracts and even international laws that have also adopted the term.
Alone among its peers, Moody's says it would support an SEC move to eliminate the NRSRO label, and adds that this would silence critics who say the SEC's blessing stifles rating-industry competition. But Moody's might simply be calling its critics' bluff — it's not alone in pointing out that NRSRO status was created for the convenience of regulators, not rating agencies. S&P, with considerably less brinkmanship, notes dryly that such a move could be "disruptive to the market."
It seems more likely, therefore, that the SEC will formalize the NRSRO application process. But doing so means establishing regulatory requirements and oversight. That could encourage newcomers by clarifying what it takes to join the industry. On the other hand, if the new rules enshrine the business models of S&P and Moody's, they would further marginalize firms like Egan-Jones.
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