Capital Markets

How Sarbox Can Cure the Rating Agencies

The Senate Banking Committee hears a call for a "simple, bright-line rule" to prevent credit raters from using their clout to gain consulting busin...
Helen ShawMarch 9, 2006

Critics citing the potential for conflicts of interests at credit- rating agencies could do worse than look to the Sarbanes-Oxley Act as a model for a solution, the leader of a prominent organization of finance executives thinks.

The potential for conflict lies in the agencies’ practice of offering rating services and consulting services to the same issuer. “A simple, bright-line rule” similar to Sarbox Title II, which lists specific activities that public accounting firms can no longer perform for their audit clients, would solve the conflict, according to Colleen Cunningham, president and chief executive officer of Financial Executives International. She testified before a Senate Banking Committee on Banking hearing on credit-rating agency reform on Tuesday.

“Rating agencies should not be permitted to provide both fee-based, advisory services and rating services to the same issuer,” Cunningham said, noting that a bifurcation of those services should guarantee that credit ratings are formed solely on a company’s creditworthiness and not on any unrelated matters.

The unrelated matters could involve attempts to trade on companies’ desire for a high credit rating. “There is concern among issuers that there is subtle pressure to purchase consulting services from your rating firm,” FEI’s general counsel Mark Prysock told in an interview.

To keep the ratings pure, agencies should publicly disclose how they make rating decisions and what conflicts of interest they might have, proposed Paul Schott Stevens, president of the Investment Company Institute, a membership organization of mutual funds and investment trusts. Greater information would enable the public to assess a rating agency’s objectivity and would be a way to sustain the integrity of credit ratings, he said.

During the hearing, speakers cited an alleged lack of competition among rating agencies as another primary issue. The five rating agencies designated as Nationally Recognized Statistical Rating Organizations (NRSROs) by the SEC —A.M. Best Co., Dominion Bond Rating Service Limited, Fitch, Moody’s Investors Service, and the Standard & Poor’s division of the McGraw Hill Cos.—have advantages over peers, according to Cunningham. That’s because the investment guidelines of government and institutional investors require NRSRO-given minimum credit ratings for securities, noted Cunningham.

The SEC’s unwillingness to bestow that designation upon more firms has made that advantage a competitive one, Cunningham testified, criticizing the current system of acquiring NRSRO status. Cunningham said she would like to see “transparent registration requirements which any credit-rating agency can understand and aim for.”

Presently, to achieve that status, a firm undergoes an SEC assessment of its operations and requests a staff no-action letter from the SEC. Such letters say that the commission will not recommend enforcement action against parties that use a given agency’s ratings. After acquiring the designated status, it is up to a firm to “police” itself and inform the SEC of any material changes to its business.

Both FEI and ICI called on Congress to introduce bills to boost competition among credit rating agencies, raise agencies’ accountability for ratings, and limit conflicts of interest. Both associations also urged Congress to grant authority to the Securities and Exchange Commission to oversee rating agencies.

For her part, a Standard & Poor’s representative testified that the rating agency opposed the push for legislation and urged the SEC to move forward with a rule on the definition of NRSROs it proposed in April 2005. Speaking on behalf of S&P, Vickie Tillman, executive vice president, agreed that the NRSRO system can be improved with a more transparent designation process to foster competition.

Tillman pointed to the European Commission’s stance against formal government regulation of rating agencies as a model market-based approach. Regulation stemming from market forces “is less likely to chill analysts from putting forth their best analysis and will not create regulatory barriers to entry for new participants” in the way government rules could, Tillman told the committee.

Further, Alex Pollock, a fellow at the American Enterprise Institute, a pro-business think tank, advocated a voluntary registration regime rather than an SEC-regulated one. Calling the five-company credit rating industry “a government-sponsored cartel,” Pollock urged Congress to mandate a pro-competitive approach toward reform.

Witnesses also called for greater accountability for the ratings process. Although designated rating agencies are subject to antifraud rules, the agencies also maintain that under the First Amendment they cannot be held liable for erroneous ratings without a finding of malice, noted Stevens of the Investment Company Institute. “NRSROs should assume some accountability for their ratings in order to provide them with [an] incentive to analyze information critically and to challenge an issuer’s representations,” he testified.

While they differed on other points, most of the speakers expressed the intention to open the industry to competition. “I think issuers would look at having more designated credit-rating agencies as a good thing,” said the FEI’s Prysock, “because it is likely to improve the quality of services and lower the costs that issuers pay for those services.”