Annual Report on Nationally Recognized
 

Statistical Rating Organizations
 

As Required by
 

Section 6 of the
 

Credit Rating Agency
 

Reform Act of 2006
 

U. S. Securities and Exchange Commission 

September 2009 
Annual Report on Nationally Recognized
 

Statistical Rating Organizations
 

As Required by Section 6 of the
 

Credit Rating Agency Reform
 

Act of2006
 

U.s. Securities and Exchange Commission 

September 2009 
TABLE OF CONTENTS
 

I.	 INTRODUCTION 1
 

II.	 COMMISSION'S PROPOSED AND ADOPTED RULES 3
 

A.	 Adopted Rule Amendments to Increase Transparency and Accountability at
 

Credit Rating Agencies 3
 

B.	 Proposed Rule Amendments to Increase Transparency and Competition 4
 

C.	 Proposed Rule Changes to Remove References to NRSRO Credit Ratings
 

From the Commission's Rules 5
 

III.	 REPORT ON ISSUES IDENTIFIED IN THE COMMISSION STAFF'S
 

EXAMINATIONS OF SELECT CREDIT RATING AGENCIES 6
 

IV.	 STATUS OF REGISTRANTS AND APPLICANTS 8
 

V.	 COMMISSION'S VIEW ON COMPETITION 8
 

A.	 Summary of Select Statistical Information 8
 

1.	 Ratings Outstanding by NRSRO 9
 

2.	 Number ofCredit Analysts Employed at Each NRSRO 11
 

3.	 NRSRO Financial Results 11
 

B.	 NRSRO Products and Other Credit Analytic Products 12
 

C.	 Regulatory and Economic Factors That Potentially Affect Competition in the
 

Credit Rating Industry 13
 

D.	 The Status of Competition among NRSROs 17
 

E.	 Assessing the Impact ofAdditional Competition 18
 

F.	 User Perspectives 19
 

G.	 The Potential Impact on Competition ofNewly Proposed NRSRO
 

Amendments and Rules 21
 

VI.	 COMMISSION'S VIEW ON TRANSPARENCY 22
 

VII.	 COMMISSION'S VIEW ON CONFLICTS OF INTEREST 24
 

VIII.	 CONCLUSION 28
 
REPORT ON NATIONALLY RECOGNIZED
 

STATISTICAL RATING ORGANIZATIONS
 

As Required by Section 6 of the Credit Rating Agency
 

Reform Act of 2006
 

I. INTRODUCTION
 

The U.S. Securities and Exchange Commission ("Commission") is providing this 

report under Section 6 of the Credit Rating Agency Reform Act of 2006 ("Rating Agency 

Act,,)).l Section 6 ofthe Rating Agency Act requires the Commission to submit an 

annual report to the Committee on Banking, Housing, and Urban Affairs of the Senate 

and the Committee on Financial Services ofthe House of Representatives that, with 

respect to the year which the report relates: 

•	 Identifies applicants for registration as nationally recognized statistical 

rating organizations ("NRSROs") under Section 15E of the Securities 

Exchange Act of 1934 ("Exchange Act"); 

•	 Specifies the number of and actions taken on such applications; and 

•	 Specifies the views of the Commission on the state of competition, 

transparency, and conflicts of interest among NRSROs. 

On June 5, 2007, the Commission approved the rules implementing a registration 

and oversight program for NRSROs under the Rating Agency Act - the rules became 

effective that same month. During the year ended June 25, 2008, the Commission 

registered the first 10 NRSROs. 

In response to the credit market turmoil, the Commission took a series of actions 

with the goal of further enhancing the utility ofNRSRO disclosure to investors, 

strengthening the integrity of the ratings process, and more effectively addressing the 

potential for conflicts of interest inherent in the ratings process for structured finance 

products. In June 2008, in the first of three related actions, the Commission proposed a 

series of amendments to its existing rules to regulate the conflicts of interests, 

disclosures, internal policies, and business practices of credit rating agencies registered as 

NRSROs.z The second action taken by the Commission was to propose a new rule that 

would require NRSROs to distinguish their ratings for structured finance products from 

other classes of credit ratings by publishing a report with the rating or using a different 

See Pub. L. No. 109-291 (2006). The Rating Agency Act became effective on June 26, 2007. The 

annual report published on June 2008 related to the period from June 26, 2007 to June 25, 2008. 

See "Annual Report on Nationally Recognized Statistical Rating Organizations", June 2008, 

http://www.sec.gov/divisions/marketreg/ratingagency/nrsroannrep0608.pdf. Consequently, the 

year to which this report relates begins on June 26, 2008 and ends on June 25, 2009. 

See "Proposed Rules for Nationally Recognized Statistical Rating Organizations", June 16, 2008, 

http://www.sec.gov/mles/proposed/2008/34-57967.pdf, ("June 16,2008 Proposing Release"). 
rating symbol." These rulemaking actions were designed to address concerns about the 

integrity ofthe credit rating procedures and methodologies ofNRSROs in the light ofthe role 

they played in determining credit ratings for securities collateralized by or linked to subprime 

residential mortgages. A summary of these two actions can be found in the annual report 

published in June 2008. The third action proposed was to remove references to NRSRO 

credit ratings from Commission rules, a step that was designed to reduce undue reliance on 

credit ratings and result in improvements in the analysis that underlies investment decisions. 4 

In February 2009, the Commission adopted, with revisions, a majority ofthe rule 

amendments proposed in the first action.i In conjunction with the adoption of these new 

measures, the Commission proposed an additional amendment which would require 

NRSROs to disclose ratings history information for 100% of all issuer-paid credit 

ratings." Finally, on the same date, the Commission re-proposed an amendment that 

would prohibit an NRSRO from issuing a rating for a structured finance product paid for 

by the product's issuer, sponsor, or underwriter unless the information about the product 

provided to the NRSRO is made available to other NRSROs.7 

In August 2007, the Commission's staff initiated examinations of the three largest 

credit rating agencies to review their role in the recent turmoil in the subprime mortgagerelated securities markets. On July 8, 2008, the Commission authorized the issuance of a 

staff report summarizing the issues identified in those examinations' The Commission 

staff found that these rating agencies struggled significantly with the increase in the 

number and complexity of subprime residential mortgage-backed securities ("RMBS") 

and collateralized debt obligations ("CDOs") deals since 2002. The examinations 

uncovered that the procedures for rating RMBS and CDas were not well documented. 

Furthermore, significant aspects ofthe rating process were not always disclosed or even 

documented by the firms, and issues were identified in the management of conflicts of 

interest. 

This report provides an overview of the rules proposed and adopted by the 

Commission during the year to which this report relates, a summary of the staff findings 

See June 16, 2008 Proposing Release.
 

See "References to Ratings Of Nationally Recognized Statistical Rating Organizations", July 1,'
 

2008, http://www.sec.gov/rules/proposed/2008/34-58070.pdf, ("July 1,2008 Proposing Release,
 

34-58070"), "Security Ratings", July 1, 2008, http://www.sec.gov/rules/proposed/2008/33­


8940.pdf, ("July 1, 2008 Proposing Release, 33-8940"), and "References to Ratings ofNationally
 

Recognized Statistical Rating Organizations", July 1, 2008,
 

http://www.sec.gov/rules/proposed/2008/ic-28327.pdf.(ccJuly1.2008ProposingRelease.IC­


28327").
 

See "Amendments to Rules for Nationally Recognized Statistical Rating Organizations", February
 

2,2009, http://www.sec.gov/rules/final/2009/34-59342.pdf, ("February 2,2009 Adopting
 

Release").
 

See "Re-proposed Rules for Nationally Recognized Statistical Rating Organizations", February 2,
 

2009, http://www.sec.gov/rules/proposed/2009/34-59343.pdf, ("February 2,2009 Re-proposing
 

Release").
 

See February 2,2009 Re-proposing Release.
 

See "Summary Report ofIssues Identified in the Commission Staffs Examinations of Select
 

Credit Rating Agencies", July 2008,
 

http://www.sec.gov/news/studies/2008/craexamination070808.pdf, ("July 2008 Staff Report").
 

2
 

6 
from the examinations of certain NRSROs, published on July 8, 2008, and addresses each 

of the items specified in Section 6 of the Rating Agency Act. 

II.	 COMMISSION'S PROPOSED AND ADOPTED RULES 

The following sections provide a description ofthe adopted rule amendments and 

pending proposed rule amendments. The Commission notes, with respect to pending rule 

proposals, any decisions about whether to adopt final rules will be made after full 

consideration of the comments received on the proposals. Further, final rules may differ 

from proposals in response to comments and other considerations. 

A.	 Adopted Rule Amendments to Increase Transparency and 

Accountability at Credit Rating Agencies 

On February 2,2009, the Commission adopted a series ofmeasures to increase 

transparency and accountability at NRSROs in order to address concerns about the 

integrity oftheir credit rating procedures and methodologies. The new requirements are 

designed to address practices identified, in part, by the Commission staff during its 

examination ofthe three largest NRSROs. In particular, the requirements are intended to 

increase the transparency of the NRSROs' rating methodologies, strengthen the 

NRSROs' disclosure ofratings performance, prohibit the NRSROs from engaging in 

certain practices that create conflicts of interest, and enhance the NRSROs' 

recordkeeping and reporting obligations to assist the Commission in performing its 

regulatory and oversight functions. The new rules: 

•	 Prohibit an NRSRO from issuing a rating where the NRSRO or a person 

associated with the NRSRO has made recommendations as to structuring 

the same products that it rates. 

•	 Prohibit anyone at an NRSRO who has responsibility for participating in 

determining credit ratings or for developing or approving procedures or 

methodologies used for determining credit ratings from negotiating the fee 

paid for a rating. 

•	 Prohibit gifts from those who receive ratings to those who rate them, apart 

from items provided in the context ofnormal business activities, such as. 

meetings, that have an aggregate value of over $25. 

•	 Require NRSROs to publish performance statistics for one, three and ten 

years within each rating category, in a way that facilitates comparison with 

their competitors in the industry. 

•	 Require disclosure of whether and how information about verification 

performed on the assets underlying a structured product is relied on in 

determining credit ratings. 

3
 
•	 Require disclosure of whether and how assessments of the quality of 

originators of assets underlying a structured product playa part in the 

determination of credit ratings. 

•	 Require disclosure ofhow frequently credit ratings are reviewed; whether 

different models are used for ratings surveillance than for initial ratings; 

and whether changes made to models are applied retroactively to existing 

ratings. 

•	 Require NRSROs to make an annual report ofthe number ofratings 

actions they took in each ratings category. 

•	 Require documentation of the rationale for any material difference 

between the rating implied by a quantitative model that is a substantial 

component in the process of determining a credit rating of a structured 

product and the final rating issued. 

•	 Require documentation, for each outstanding credit rating, of all rating 

actions and the date of such actions from the initial credit rating to the 

current credit rating. 

•	 Require documentation of any written communications received from 

persons not associated with the NRSRO that contain complaints about the 

performance of a credit analyst. 

•	 Require NRSROs to make publicly available on a six month delay, a 

random sample of 10% of the rating action histories of credit ratings paid 

for by the obligor being rated or by the issuer, underwriter, or sponsor of 

the security being rated ("issuer-paid credit ratings") in each class of credit 

ratings for which it is registered and has issued 500 or more issuer-paid 

credit ratings. 

B.	 Proposed Rule Amendments to Increase Transparency and 

Competition 

In conjunction with the adoption ofthe final rule amendments to its existing rules 

governing the conduct ofNRSROs, discussed above, on February 2,2009, the 

Commission proposed additional amendments designed to address further concerns about 

the integrity ofthe credit ratings procedures and methodologies at NRSROs. The 

Commission proposed an amendment that would require the public disclosure of credit 

rating histories, subject to a 12 month delay, for all outstanding credit ratings determined 

by an NRSRO, on or after June 26, 2007, paid for by the obligor being rated or by the 

issuer, underwriter, or sponsor of the security being rated. The purpose of the proposed 

amendment is to provide users of credit ratings, investors and other market participants 

and observers with more effective raw data with which to compare how NRSROs subject 

to the rule initially rated an obligor or security and, subsequently, adjusted those ratings, 

4
 
including the timing of the adjustments. The Commission preliminarily believes that 

requiring the disclosure of the ratings action history of each issuer-paid credit rating 

could create the opportunity for market participants to use the information to develop 

performance measurement statistics that would supplement those required to be published 

by the NRSROs themselves in Form NRSRO. 

Finally, on the same date, the Commission re-proposed an amendment to its 

conflict of interest rule that would prohibit an NRSRO from issuing a rating for a 

structured finance product paid for by the product's issuer, sponsor, or underwriter unless 

the information about the product provided to the NRSRO is made available to other 

persons. NRSROs that are hired by arrangers to perform credit ratings for structured 

finance products would need to disclose to other NRSROs (and only other NRSROs) the 

deals for which they were in the process of determining such credit ratings. The arrangers 

would need to provide the NRSROs they hire to rate structured finance products with a 

representation that they will provide information given to the hired NRSRO to other 

NRSROs (and only other NRSROs). NRSROs seeking to access information maintained 

by the NRSROs and the arrangers would need to furnish the Commission with an annual 

certification that they are accessing the information solely to determine credit ratings and 

will determine a minimum number of credit ratings using the information. 

The purpose of the re-proposed amendment is to increase the number of ratings 

extant for a given structured finance security or money market instrument and, in 

particular, promote the issuance of ratings by NRSROs that are not hired by the arranger. 

This could provide users of credit ratings with a broader range of views on the 

creditworthiness of the security or money market instrument and potentially expose an 

NRSRO that was unduly influenced by the "issuer-pay" conflict into issuing higher than 

warranted ratings. 

C.	 Proposed Rule Changes to Remove References to NRSRO Credit 

Ratings from the Commission's Rules 

On July I, 2008, the Commission proposed amendments to existing Commission 

rules that rely on credit ratings. The proposed amendments, in many cases, would 

remove or revise such references. The proposals also responded to recommendations 

issued by the President's Working Group on Financial Markets, the Financial Stability 

Forum and the Technical Committee of the International Organization of Securities 

Commissions (IOSCO). 9 Consistent with these recommendations, the Commission is 

considering whether the inclusion ofrequirements related to ratings in its rules and forms 

has, in effect, created the appearance of an "official seal of approval" on ratings that 

could adversely affect the quality of due diligence and investment analysis. The 

See President's Working Group on Financial Markets, "Policy Statement on Financial Market 

Developments" (March 2008), available at www.ustreas.gov ("PWG Statement"); "The Report of 

the Financial Stability Forum on Enhancing Market and Institutional Resilience", April 2008, 

available at www.fsforum.org ("FSF Report"); Technical Committee of the International 

Organization of Securities Commissions, "The Role of Credit Rating Agencies in Structured 

Finance Markets - Final Report", May 2008, available at www.iosco.org. 

5 

9 
Commission's proposals are designed to lessen reliance on credit ratings and promote 

independent analysis in making investment decisions. 

The proposed rules were published in three releases. In the first release, the 

Commission proposed to amend various rules and forms under the Securities Exchange 

Act of 1934 ("Exchange Act") administered by the Commission's Division of Trading 

and Markets that rely on NRSRO ratings. The proposal would remove references to 

NRSROs in the following rules and forms: Rule 3a1-1, Rule l Ob-lO, Rule 15c3-1, Rule 

15c3-3, Rules 101 and 102 of Regulation M, Regulation ATS, Form ATS-R, Form 

PILOT and Form X-17A-5 Part IIB. 10 

In the second release, the Commission proposed amendments to Regulation S-K, 

and rule and form requirements under the Securities Act of 1933 ("Securities Act") and 

the Exchange Act that are administered by the Commission's Division of Corporation 

Finance. In Regulation S-K, the Commission proposed to amend Items 10, 1100, 1112, 

and 1114. Under the Securities Act, the Commission proposed to amend Rules 134, 138, 

139, 168,415,436, Form S-3, Form S-4, Form F-1, Form F-3, Form F-4 and Form F-9. 

The Commission also proposed to amend Schedule 14A under the Exchange Act. l l 

In the third release, the Commission proposed to amend four rules under the 

Investment Company Act of 1940 ("Investment Company Act") and one rule under the 

Investment Advisors Act of 1940 ("Investment Advisors Act") that are administered by 

the Commissions Division of Investment Management and that rely on NRSRO ratings. 

The Commission proposed amendments to Rules 2a-7, 3a-7, 5b-3 and 10f-3 under the 

Investment Company Act and amendments to Rule 206(3)-3T under the Investment 

Advisors Act. 12 

III.	 REPORT ON ISSUES IDENTIFIED IN THE COMMISSION STAFF's 

EXAMINATIONS OF SELECT CREDIT RATING AGENCIES 

On July 8, 2008, the Commission released findings from extensive l Ovmonth staff 

examinations ofthree credit rating agencies - Fitch Ratings, Inc., Moody's Investors 

Service, Inc. and Standard & Poor's Ratings Services - regarding their role in the turmoil 

in the subprime mortgage-related securities markets. The focus of the examinations was 

the rating agencies' activities in rating subprime RMBS and CDOs linked to subprime 

residential mortgage-backed securities. The staff found: 

•	 There was a substantial increase in the number and in the complexity of 

RMBS and CDO deals since 2002, and some of the rating agencies appear 

to have struggled with the growth. 

•	 Significant aspects of the ratings process were not always disclosed. 

10 See July 1, 2008 Proposing Release, 34-58070. II See July 1, 2008 Proposing Release, 33-8940. 

12 See July 1,2008 Proposing Release, IC-28327. 

6
 
•	 Policies and procedures for rating RMBS and CDOs can be better 

documented. 

•	 The rating agencies are implementing new practices with respect to the 

information provided to them. 

•	 The rating agencies did not always document significant steps in the 

ratings process, including the rationale for deviations from their models 

and for rating committee actions and decisions, and they did not always 

document significant participants in the ratings process. 

•	 The surveillance processes used by the rating agencies appear to have 

been less robust than the processes used for initial ratings. 

•	 Issues were identified in the management of conflicts ofinterest and 

improvements can be made. 

•	 The rating agencies internal audit processes varied significantly. 

The report summarized generally the remedial actions the staff recommended, 

including that each NRSRO: 

•	 Evaluate whether it has sufficient staff and resources to manage its volume 

of business and meet its obligations under the Exchange Act and the rules 

applicable to NRSROs. 

•	 Review disclosure of the ratings process and the methodologies used to 

rate RMBS and CDOs to ensure full compliance with SEC rules. NRSROs 

should review whether policies governing the timing of disclosure of a 

significant change to a process or methodology are reasonably designed to 

comply with applicable SEC disclosure requirements. 

•	 Determine whether written policies and procedures used to determine 

credit ratings for RMBS and CDOs are fully documented. 

•	 Review current policies and practices for documenting the credit ratings 

process and the identities ofRMBS and CDO ratings analysts and 

committee members. 

•	 Determine if adequate resources are devoted to surveillance of outstanding 

RMBS and CDO ratings. 

•	 Review practices, policies and procedures for mitigating and managing the 

"issuer pays" conflict of interest. 

7 
•	 Review policies and procedures for managing the securities ownership 

conflict ofinterest to determine whether these policies are reasonably 

designed to ensure that employees' personal trading is appropriate and in 

compliance with applicable requirements. 

•	 (as to two ofthe NRSROs examined) Review whether internal audit 

functions, particularly in the RMBS and CDO ratings areas, are adequate 

and whether they provide for proper management follow-up. 

IV. STATUS OF REGISTRANTS AND APPLICANTS 

Ten credit rating agencies have applied for and been granted registration as 

NRSROs. The registered credit rating agencies and the dates of their registration are: 

NRSRO Date of Registration 

A.M. Best Company, Inc. ("A.M. Best") September 24, 2007 

DBRS Ltd. ("DBRS") September 24, 2007 

Fitch, Inc. ("Fitch") September 24, 2007 

Japan Credit Rating Agency, Ltd. ("JCR") September 24, 2007 

Moody's Investors Service, Inc. ("Moody's") September 24, 2007 

Rating and Investment Information, Inc. ("R&I") September 24, 2007 

Standard & Poor's Ratings Services ("S&P") September 24, 2007 

Egan-Jones Rating Company ("EJR") December 21, 2007 

LACE Financial Corp. ("LACE") February 11,2008 

Realpoint LLC ("Realpoint") June 23, 2008 

There was one application received during the period covered by the second 

annual report. The application was withdrawn after the period covered by the report and 

prior to the end of the 90-day period prescribed in the Rating Agency Act for the 

Commission to grant the application or initiate proceedings to determine whether it 

should be denied. 

V. COMMISSION'S VIEW ON COMPETITION 

A. Summary of Select Statistical Information 

As discussed above, the Commission has granted NRSRO registration to 10 credit 

rating agencies. The first seven firms (A.M. Best, DBRS, Fitch, JCR, Moody's, R&I, and 

S&P) applied for registration as NRSROs in June of2007 under the new registration and 

oversight program adopted by the Commission that month. Subsequently, the 

Commission granted three additional credit rating agencies NRSRO registration (EJR, 

LACE, and Realpoint). The following sections summarize certain information reported 

by each NRSRO on its Form NRSRO. 

8
 
1. Ratings Outstanding by NRSRO 

The table below reports the number of outstanding ratings reported by each 

NRSRO in its Form NRSRO annual certification for the year 2008. For each NRSRO, the 

table sets forth the number of outstanding ratings for the five classes of ratings identified 

in Section 3(a)(62) of the Exchange Act: (1) financial institutions, brokers, or dealers; (2) 

insurance companies; (3) corporate issuers; (4) issuers of asset-backed securities; 13 and 

(5) issuers of government securities, municipal securities, or securities issued by a foreign 

government ("sovereign securities"). 14 

Outstanding Credit Ratings Reported by NRSROs on
 

Form NRSRO by Ratings Class
 

NRSRO Financial 

Institutions 

Insurance 

Companies 

Corporate 

Issuers 

AssetBacked 

Securities 

Government, 

Municipal & 

Sovereign 

Securities 

Total 

Ratings 

A.M. Best 3 6,009 2,710 54 0 8,776 

DBRS 18,040 110 7,080 7,470 10,560 43,260 

EJR 62 46 803 14 9 934 

Fitch 83,649 4,797 14,757 77,480 491,264 671,947 

JCR 155 31 544 71 71 872 

LACE 18,000 100 2,000 0 300 20,400 

Moody's 84,773 6,277 31,126 109,261 880,880 1,112,317 

R&I 100 32 600 210 100 1,042 

Rea1point 0 0 0 9,200 0 9,200 

S&P 47,300 6,600 26,900 198,200 976,000 1,255,000 

Total 

Ratings 

252,082 24,002 86,520 401,960 2,359,184 3,123,748 

HHI 2,686 2,467 2,636 3,550 3,539 3,347 

Of the ten credit rating agencies registered with the SEC as NRSROs, seven 

operate predominantly under the issuer-pay model. I5 The remaining three operate 

predominantly under the subscriber-pay model. 16 The NRSROs operating under the 

13 As the term is defined in 17 CFR 229.110 1(c). 14 There are a variety of ways of tabulating the number of outstanding ratings and different methods 

can result in different outcomes, particularly in the class of ratings of government securities. For 

example, a public finance issue which has multiple series with different maturity dates can be 

counted as a single rating or, alternatively, each series can be counted separately. At the request of 

the staff, Moody's recalculated the number ofpublic finance ratings it has outstanding by counting 

each rating for a security with a different maturity date separately in order to place the number it 

reports on a more comparable basis to the numbers reported by certain other NRSROs. Moody's 

reported to the staff that the approximate number of ratings in the class of government securities, 

based on this method, was approximately 880,880. Moody's reported 192,953 ratings in the class 

of government securities on its Form NRSRO. 15 A.M. Best Company, Inc., DBRS Ltd., Fitch, Inc., Japan Credit Rating Agency, Ltd., Moody's 

Investors Service, Rating and Investment Information, Inc., Standard and Poor's Ratings Services. 16 Egan-Jones Rating Company, LACE Financial Corp., Realpoint LLC. 

9 
issuer-pay model have determined approximately 99% of the total currently outstanding 

credit ratings issued by NRSROs. 17 

Market concentration is generally measured by economists using the HerfindahlHirschman Index (HHI), which is a measure ofthe size of firms in relationship to the 

industry and an indicator of the amount of competition among them. It is calculated by 

squaring the market share of each firm competing in the market and then summing the 

resulting number. The HHI is measured on a scale of

°to 10,000 and approaches zero 

when a market consists of a large number of firms ofrelatively equal size. The HHI 

increases both as the number of firms in the market decreases and as the disparity in size 

between those firms increases. According to the U.S. Department of Justice, markets in 

which the HHI is between 1,000 and 1,800 points are considered to be moderately 

concentrated, and those in which the HHI is in excess of 1,800 points are considered to be 

concentrated. I8 

The HHI for all NRSRO ratings outstanding is 3,347, which is the equivalent of 

(10,000/3,347) 3 equally sized firms. Three NRSROs (Fitch, Moody's, and S&P) issued 

approximately 97% of all outstanding ratings across all categories reported. The 

concentration of outstanding ratings for these three NRSROs is high across all five 

categories, but does vary across those categories. For instance, Fitch, Moody's, and S&P 

account for over 99% of all outstanding ratings for government securities, but less than 

74% of all ratings for insurance companies. For reasons, including those discussed below 

in section V.C., concentration needs to be considered together with other factors to 

identify the level of competition. 

Among these three large NRSROs, concentration is not consistent across rating 

classes. For credit ratings related to financial institutions, Fitch and Moody's each had 

almost twice as many outstanding ratings as did S&P. Moody's and S&P were the two 

dominant issuers of credit ratings for corporate issuers. 

Among the other NRSROs, DBRS and LACE report having the two largest 

numbers of outstanding credit ratings for financial institutions (18,040 and 18,000 

respectively or approximately 7% each of all ratings in the category) while A.M. Best 

reports the largest number of outstanding ratings for the insurance company category 

(6,009 for 25% of all ratings in this category). DBRS reports the largest number of 

outstanding ratings for the corporate sector (7,080 for 8.2% of all ratings within this 

category). 

After credit ratings for government, municipal and sovereign securities, the next 

highest level of concentration is in the provision of credit ratings for asset-backed 

securities.i" Specifically, of the over 401,960 outstanding ratings in this credit rating 

class, all but 17,019 are issued by Fitch, Moody's, and S&P. Among the otherNRSROs, 

17	 According to Forms NRSRO made public by NRSROs. 

18	 http://www.usdoj.gov/atr/public/testimony/hhi.htm. 19	 Fitch, Moody's, and S&P issued 2,348,144 of the total 2,359,184 credit ratings for government, 

municipal and sovereign securities and issuers. 

10
 
Realpoint reports having the largest number of outstanding credit ratings for asset-backed 

securities (9,200 for 2.3% of all ratings in the category). 

The HHI for all credit ratings outstanding has declined from 3,778 reported in the 

first annual report to 3,347 this year.20 

2. Number of Credit Analysts employed at each NRSRO 

The table below reports the total number of credit analysts and credit analyst 

supervisors employed at each NRSRO as reported by each NRSRO in Exhibit 8 of its 

FormNRSRO. 

Credit Analysts and Credit Analyst Supervisors Employed at Each NRSRO 

NRSRO Credit 

Analysts 

Credit 

Analyst 

Supervisors 

A.M. Best 144 50 

24 

3 

305 

23 

4 

126 

8 

7 

228 

778 

DBRS 62 

EJR 12 

Fitch 1,057 

JCR 59 

LACE 8 

Moody's 1,124 

R&I 80 

Realpoint 15 

S&P 1,081 

Total 3,642 

The three largest credit rating agencies report employing 3,262 credit analysts or 

approximately 90% ofthe total number of credit analysts employed by all of the 

NRSROs. Among the other NRSROs, A.M. Best reported employing the largest number 

of credit analysts (144 or approximately 4% of the total number of credit analysts). 

3. NRSRO Financial Results 

Exhibit 12 to Form NRSRO requires each NRSRO to provide information as to 

the amount of revenue generated from various credit rating services and a separate 

computation oftotal revenue from all other services. In addition, Exhibit 11 to Form 

NRSRO requires each NRSRO to furnish the Commission with audited financial 

The decline is primarily due to the increase in the number of Moody's ratings reported in the class 

of government securities as a result of the change in the method of counting public finance ratings 

discussed in footnote 14. Without that change, the HHI is 3,723 which is only slightly lower than 

last years HHI. In addition, one NRSRO which previously reported outstanding ratings based on 

the number of rated issuers is now reporting the number of rated issues resulting in an increase in 

its outstanding ratings across all classes of ratings for which it assigns ratings. 

11 

20 
statements for the past three fiscal or calendar years. An NRSRO will not be required to 

make any ofthis information publicly available pursuant to Section 15E(a)(3) ofthe 

Exchange Act and Rule 17g-l (i) thereunder. 

The total revenue reported by all of the NRSROs was approximately $3.8 billion 

dollars. 21 The HHI for total revenues reported by NRSROs is 3,267 which is the 

equivalent of 3.1 equally sized firms. The HHI for earnings reported by NRSROs is 3,924 

which the equivalent of2.55 equally sized firms. The HHI for earnings is higher than the 

HHI for revenue because the firms which reported the largest amounts ofrevenue also 

tended to have higher after-tax profit margins. 

B. NRSRO Products and Other Credit Analytic Products 

Ratings produced by credit rating agencies, including NRSROs, are generally 

letter-based symbols intended to reflect assessments of credit risk for various entities 

issuing debt obligations in public markets. These credit assessments are designed to 

measure and predict the probability of default, or the expected loss, a measure which also 

includes an assessment ofloss given default, for an individual debt obligation or for an 

obligor. These assessments, in most cases, reflect a variety of quantitative and qualitative 

factors which vary based on sector. In addition, rating agencies may employ different 

rating scales for different regions, sectors, jurisdictions or types of securities. For 

example, the rating scale a rating agency employs to assign short term obligations may 

differ from the rating scale it uses for long term obligations. Ratings are described by the 

credit rating agencies as intended to reflect only credit risk, not other valuation factors 

such as liquidity or currency risk. Thus, while bond yields are strongly correlated with 

credit ratings, ratings are not the sole determinant of prices. 

Demand for credit ratings exists from investors, both individual and institutional, 

who value an independent assessment of the relative or absolute credit risk of a particular 

debt obligation or obligor. As such, credit ratings serve a certification function in the 

marketplace, providing issuers with higher ratings and less costly access to debt 

markets.v' In many cases, investment managers and financial institutions are required by 

regulations, including Commission rules, to use ratings to establish investment risk 

standards for their portfolio holdings.i" Parties can write contracts that create obligations 

21 The fiscal year end used by different NRSROs as a basis for their reporting varied from September 

2008 to March 2009. 

22 See, ~, Partnoy (1999), or Boot, et a1. (2006). Kerwer (2002) and Sinclair (2000) argue that 

credit ratings agencies create value through standardizing the credit assessment process. Frank 

Partnoy, 1999, "The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit 

Ratings Agencies," Washington University Law Quarterly, 77 (3), 619-714. Arnoud W.A. Boot, 

Todd T. Milbourn and Anjolein Schmeits, 2006, "Credit Ratings as Coordination Mechanisms," 

Review ofFinancial Studies, 19 (1), 81-118. Deiter Kerwer, 2002, "Ratings Agencies: Setting a 

Standard for Global Financial Markets," Economic Sociology European Electronic Newsletter, 3 

(3),40-46. Timothy J. Sinclair, "Reinventing Authority: Embedded Knowledge Networks and the 

New Global Finance," Environment and Planning C: Government and Policy, 18 (4),487-502. 23 See, ~, European Central Bank, "Market Dynamics Associated with Credit Ratings: A Literature 

Review," Occasional Paper Series No. 16, 2004. 

12
 
based on a change in ratings - the use ofso-called "ratings triggers" (see additional 

discussion in following section). 

In addition to NRSROs and other credit rating agencies, the staff is aware of other 

relevant providers of credit research and analysis." Credit models and assessments by 

third-party providers may be used by investors as indicators of value or price for a given 

debt obligation. Where available, third-party providers of credit analytics and internal 

models are natural competitors to NRSROs for all non-regulatory uses, and may serve as 

a check on NRSRO ratings quality or substitutes for non-regulatory uses if they provide 

more accurate or useful ratings. 

Economists point to several factors that have increased the demand for credit 

ratings in recent years." Structural changes in financial markets have increased the 

number of participants, increased their anonymity, and increased the complexity of their 

investment strategies. At the same time, financial disintermediation shifted credit from 

banks to capital markets, leading to the creation ofincreasingly complex financial 

instruments through securitization. The increasing complexity likely created additional 

reliance by investors on NRSRO ratings as they provided a single summary measure of 

the credit risks of difficult to evaluate financial instruments. At the same time, banking 

and finance regulators around the world have increased their reliance on NRSRO ratings. 

As noted above, NRSROs are one type of credit rating agency providing thirdparty credit assessments to the market. When users of credit assessments for nonregulatory purposes also need NRSRO ratings for regulatory purposes, they may choose 

to purchase only NRSRO ratings so as to avoid purchasing both. The economic case for 

purchasing a non-NRSRO credit assessment may be even more difficult if the credit 

rating agency is a newer entrant, without the same established level of reputation even 

when that assessment is valuable to the investor. 

C.	 Regulatory and Economic Factors that Potentially Affect Competition 

in the Credit Rating Industry 

The Findings section of the Rating Agency Act noted that "the 2 largest credit 

rating agencies serve the vast majority ofthe market.,,26 Further, the Senate Report 

accompanying the Rating Agency Act described the largest two NRSROs (Moody's and 

S&P) as a "duopoly" or "partner-monopoly.v'" Information obtained from NRSROs 

about the number ofratings they have outstanding, the number of credit analysts and their 

financial results, presented above suggests that in combination with Fitch, these two 

entities still are dominant market players. 

24	 See, .sc:.g., Arturo Estrella, "Credit Ratings and Complementary Sources of Credit Quality 

Information", Basel Committee on Banking Supervision Working Papers, August 2000. 25 See,~, Fabian Dittrich, 2007, "The Credit Rating Industry: Competition and Regulation", 

Doctoral Dissertation, Universitat zu Koln, Koln, Germany and Isabelle Gras, 2003, "The Power 

to Rate," REGEM Analysis No.6. 26 See Section 2 of the Rating Agency Act (Pub. L. No. 109-291 (2006)). 27 See Senate Report, 109-326, p.l. 

13
 
Economists note that the credit rating industry has exhibited a high level of 

concentration throughout much of its history, dating from the early twentieth century." 

Analysts have cited the regulatory use of ratings as a factor that has created barriers to 

entry and led to concentration in the credit rating industry.i" Financial regulators 

including the Federal Reserve Banks, the Office of the Comptroller of the Currency and 

state banking and insurance departments have used credit ratings to assist them in their 

oversight of financial institutions since the 1930s. Early ratings-dependent rules included 

requirements to mark to market lower rated bonds and restrictions on purchase of 

speculative securities. In the 1950s, the National Association ofInsurance Companies 

imposed higher capital requirements on the lower rated bonds of insurance companies.i" 

The Commission first used the term NRSRO in 1975 in the net capital rule for 

broker-dealers (Rule l5c3-l) as an objective benchmark to prescribe capital charges for 

different types of debt securities. Since then, the Commission has used the designation in 

a number of regulations. Although the use of the term NRSRO was originated for a 

narrow purpose in the Commission's own regulations, ratings by NRSROs today are used 

widely as benchmarks in federal and state legislation, and rules issued by other financial 

regulators. 

Congress has incorporated the NRSRO concept into a wide range of financial 

legislation. For example, when Congress defined the term "mortgage related security" in 

Section 3(a)(4l) of the Exchange Act as part of the Secondary Mortgage Market 

Enhancement Act of 1984, it required, among other things, that such securities be rated in 

one of the two highest rating categories by at least one NRSRO. Further, in 1989, 

Congress added the NRSRO concept to the Federal Deposit Insurance Act, prescribing 

that corporate debt securities are not "investment grade" unless they are rated in one of 

the four highest categories by at least one NRSRO. 31 

Finally, a number of other federal and state laws and regulations today employ the 

NRSRO concept. For example, the U.S. Department of Education uses ratings from 

NRSROs to set standards of financial responsibility for institutions that wish to 

participate in student financial assistance programs under Title IV of the Higher 

Education Act of 1965, as amended (Title IV). In addition, several state insurance codes 

rely, directly or indirectly, on NRSRO ratings in determining appropriate investments for 

insurance companies. Most recently, credit ratings have been used to determine the 

28 See,~, Richard SyIla, "A Historical Primer on the Business of Credit Ratings" and Lawrence J. 

White, "The Credit Rating Industry: an Industrial Organization Analysis" both papers in "Ratings, 

Rating Agencies and the Global Financial System (The New York University Salomon Center 

Series on Financial Markets and Institutions)", edited by Richard M. Levich, Giovanni Majnoni, 

and Carmen Reinhart, 2002. 29 See,~, Partnoy (1999), White (2001).
 30 See,~, Richard Cantor and Frank Packer, "The Credit Rating Industry", FRBNY Quarterly
 

Review, Summer-Fall, 1994. 31 See "Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities 

Markets As Required by Section 702(b) of the Sarbanes-Oxley Act of2002", 

http://www.sec.gov/news/studies/credratingreportO103.pdf, January, 2003. 

14
 
eligibility of assets for a number ofthe programs established by the Federal Reserve and 

the Department ofthe Treasury in response to the credit crisis. 32 . 

Credit ratings are also used widely by financial regulators outside the United 

States. 33 According to a Basel Committee on Banking Supervision (BCBS) study 

published in 2000, eleven out of twelve countries that are members ofthe BCBS used the 

ratings of credit rating agencies in financial regulatory supervision." The Basel II 

framework, which has been implemented by members ofthe European Union, relies on 

the ratings of credit rating agencies recognized as External Credit Assessment Institutions 

(ECAI) in order to calculate bank capital requirements within its standardized approach 

fior ereditIt rinsk measurement. 35 

Economies ofscale and sunk costs may be economic factors which may favor the 

larger long established rating agencies. Large rating agencies can allocate the costs of 

analytical software, administrative, legal, compliance, marketing and support staff, 

among other costs, across a wider range of ratings providing a more efficient cost base. In 

addition, these rating agencies have large sunk costs in the form of developed ratings, 

methodologies and procedures and ratings outstanding which new entrants must create 

from scratch.i" 

The importance of reputation is another economic factor that is often cited by 

analysts.V When the quality of a firm's product is difficult to assess at the time of 

purchase, consumers often use the quality of prior products produced by the firm as a 

benchmark for their purchasing decision.i" A firm that has a long history of producing 

quality products develops a reputational asset which allows it to command a higher price. 

The value of this reputational asset can provide an incentive for the firm to continue to 

produce high quality products." 

Credit ratings are an example of a product whose quality, at time of purchase, is 

particularly difficult to evaluate. In most cases, credit ratings are estimates about the 

probability of default or expected loss for a given debt obligation or obligor. Defaults are 

expected to occur rarely and are highly sensitive to macroeconomic forces which may be 

32 See,~, "Term Asset-Backed Securities Loan Facility: Terms and Conditions", May, 2009, 

http://www.newyorkfed.org/markets/talf, tenns.html. 33 See The Joint Forum, "Stocktaking on the use of credit ratings", June 2009, available at 

www.iosco.org ("June 2009 Joint Forum Report"). 34 See Arturo Estrella, "Credit Ratings And Complementary Sources OfCredit Quality Information", 

Basel Committee On Banking Supervision Working Papers No.3, August 2000. 35	 See, Basel Committee on Banking Supervision, "International Convergence of Capital 

Measurement and Capital Standards: A Revised Framework - Comprehensive Version", June 

2006. 36	 See,~, Herwig M. Langohr, "The Credit Rating Agencies and Their Credit Ratings", address 

given to the Bond Market Association in Paris in February 2006. 37 See, ~, Dittrich (2007). 38 See, ~, Carl Shapiro, "Premiums for High Quality Products as Returns to Reputations", 

Quarterly Journal ofEconomics 98(4): 659-79, November 1983. 39 See,~, Benjamin Klein and Keith Leffler, "The Role of Market Forces in Assuring Contractual 

Performance", Journal of Political Economy, Vol. 89, No. 41,1981. 

15 
difficult to forecast. The accuracy and consistency ofratings produced by a given rating 

agency may only be revealed over an extended period. Because it is difficult to evaluate a 

particular credit rating easily, establishing and maintaining a reputation for ratings 

accuracy, a process which can take years, is very important for any credit rating agency. 

A rating agency's reputation can be damaged by a failure to continue to assign 

ratings accurately. The assignment ofhigh credit ratings to many RMBS and CDO 

securities in recent years followed by the scope and magnitude of subsequent downgrades 

during the current credit crisis has resulted in a loss of confidence among investors in the 

reliability of credit ratings issued by the largest NRSROs in this sector. This lack of 

confidence in the accuracy ofNRSRO ratings has been a factor in the broader dislocation 

in the credit markets. In the wake of these events, the NRSROs that rated subprime 

RMBS and CDOs have come under intense criticism and scrutiny, although their market 

share does not seem to be affected by any diminished reputation. 

"Network externalities" may also playa role in the credit rating industry. Network 

externalities which are often considered in connection with such products as computer 

operating systems or video recorders exist when the value of a product increases as more 

people use it.4o Network externalities can create a significant obstacle to entry for a new 

entrant in an industry where these effects are strong. In these types of industries, a 

company may make a product which has superior attributes to an entrenched competitor 

and still fail to win market share. The procedures and methodologies of a rating agency 

create a standardized way oflooking at credit risk and one function ofthe rating is to 

facilitate communication about credit risk among market participants." Another function 

of credit ratings is to facilitate comparisons between credit instruments within a sector 

and potentially across sectors. Market participants may consider how widely the ratings 

of a particular rating agency are used by other investors and the breadth of coverage a 

rating agency provides as factors in determining the usefulness ofits ratings.V 

A wide range of private contractual agreements which reference the ratings of 

particular rating agencies create another barrier to entry for new entrants." These include, 

for example, minimum ratings requirements that specify the ratings of specific rating 

agencies in the investment management contracts of institutional fund managers and the 

investment guidelines of fixed income mutual fund managers, pension plan sponsors, and 

endowment fund managers. In addition, fixed income indices used to evaluate the 

40 See, ~, Michael L. Katz and Carl Shapiro, "Network Externalities, Competition, and 

Compatibility", The American Economic Review, Vol. 75, No.3, pp. 424-440, June 1985. For 

application to credit rating industry see Langohr (2006), Jerome S. Fons, "White Paper on Rating 

Competition and Structured Finance", January 2008. 41 See, ~, Kerwer (2002). 42 See, ~, Langhohr (2006), Fons (2008). 43 See, ~, Richard Cantor, Owain ap GwiIym, Stephen Thomas, "The Use of Credit Ratings in 

Investment Management in the U.S. and Europe", The Journal of Fixed Income, Vol. 17, No.2, 

Fall 2007; H. Kent Baker and Sattar A. Mansi, "Assessing Credit Rating Agencies by Bond 

Issuers and Institutional Investors", Journal ofBusiness Finance & Accounting, Volume 29, 

Numbers 9-10, November/December 2002; G. Timothy Haight, George Engler and Kenneth J. 

Smith, "An Examination of the Characteristics of College Endowment Funds", Journal of 

Investing, Fall 2006. 

16 
performance ofinvestment managers often have inclusion characteristics which refer to 

the ratings of specific rating agencies. The effect ofthese contractual agreements can be 

to increase the demand and liquidity for securities bearing the ratings of specific 

providers. 

In addition, ratings triggers are commonly found in bank loan agreements, 

guaranteed investment contracts, and the credit support annexes and other provisions of 

derivatives contracts. 44 When ratings triggers are present, a decline in the rating of an 

issuer or obligor below a certain level can alter the obligations of parties to an agreement, 

for example, providing a counterparty to a derivatives contract with the right to demand 

collateral or lenders the right to demand repayment of a loan. The ratings ofspecific 

rating agencies are often specified in such agreements. The extensive use of credit ratings 

in private contracts has enhanced the importance of credit ratings to the marketplace. 

Barriers that prevent some NRSROs from obtaining information needed to assign 

ratings may also limit competition, particularly with respect to structured finance 

products. Generally, when the issuer-paid model is employed, the information relied on 

by the hired NRSROs to rate structured finance products is non-public. This makes it 

difficult for other NRSROs to rate these securities. As a result, the products frequently 

are issued with ratings from only one or two NRSROs and only by NRSROs that are 

hired by the issuer, sponsor, or underwriter. In addition, investors may also tend to place 

greater weight on an opinion that is based, in part, on access to privileged information.Y 

D. The Status of Competition among NRSROs 

Since the enactment of the Rating Agency Act and the adoption of the 

Commission's rules thereunder, ten firms have registered as NRSROs with the 

Commission. The first seven firms applied for registration as NRSROs in June of2007 

under the new registration and oversight program adopted by the Commission that 

month. Subsequently, the Commission granted three additional credit rating agencies 

NRSRO registration. The ratings available from these three newest NRSROs increase the 

total number of available outstanding credit ratings that can be relied upon for regulatory 

purposes by about 30,500. In addition, the three newest NRSROs operate primarily under 

the subscriber-pay compensation model, providing users ofratings an alternative to the 

issuer-pay model employed by the seven NRSROs which applied for registration in June 

2007. 

Although the credit ratings of the two largest NRSROs now represent a smaller 

proportion of all NRSRO ratings, the Commission is unable to discern from this data the 

impact ofNRSRO registration on the demand for or the provision of credit ratings for 

several reasons. First, the registration and oversight program implemented by the 

Commission under the Rating Agency Act that requires disclosure of information about 

44 See, ~, Moody's Special Comment, "2008 Rating Trigger Trends in the U.S. Life 

(Re)Insurance Industry", January, 2009. 45 See,~, Philippe Jorion, Zhu Liu, and Charles Shi, "Informational Effects of Regulation FD: 

Evidence from Rating Agencies", Journal of Financial Economics, May 2005. 

17 
outstanding ratings for NRSROs is less than two years old. In addition, the credit crisis, 

while potentially creating additional long term demand for providers of credit ratings and 

research has reduced debt issuance in a number of sectors. Consequently, there is 

insufficient history to evaluate the impact that being registered as an NRSRO has had on 

obtaining additional business. 

Second, comparing the number of outstanding ratings ofthe long established 

NRSROs and newly registered NRSROs may not provide a complete picture. The large 

NRSROs may have a significantly longer history ofissuing ratings and their reported 

outstanding ratings include ratings for debt obligations (and obligors) that may have been 

rated long before the establishment ofthe newer entrants. Consequently, a comparison of 

the number ofratings being determined for more recent issuances may provide a better 

gauge of how well newer entrants are competing with more established firms. 

Third, as noted above, all seven of the NRSROs which applied for registration in 

June 2007 operate primarily on an issuer-pay compensation model, whereas the three 

newer NRSROs primarily rely on a subscriber-pay compensation model. For the earlierregistered NRSROs, each outstanding rating was provided based on the demand by a 

paying client (the issuer) for that individual rating. Increases and decreases in total 

number of outstanding ratings reflect trends in securities issuances and the demand for 

the specific rating by identifiable clients from that NRSRO. 

The subscriber-pay compensation model is a different economic model. 

Subscriber-pay NRSROs typically attract customers who want access to at least some of 

their credit ratings. Investors and other market participants purchase the right to access 

the pool of credit ratings issued by these NRSROs and are not necessarily users of all 

credit ratings provided. Thus, a client of a subscriber-pay NRSRO may request a rating 

on an individual security or those securities of a specific issuer or class ofissuers, but a 

reported increase in the number of securities rated by the NRSRO as part of its regulatory 

filings does not necessarily demonstrate that those additional credit ratings were 

specifically demanded by investors or that they are being relied upon by market 

participants widely. 

E. Assessing the Impact of Additional Competition 

As noted above, the Senate Report accompanying the Rating Agency Act stated 

that the statute's purpose was to "improve ratings quality for the protection ofinvestors 

and in the public interest by fostering accountability, transparency, and competition in the 

credit rating industry.T'" The Senate Report also noted that competition would "provide 

investors with more choices, higher quality ratings, and lower costS.,,47 Competition can 

lead to credit ratings that are of higher quality to investors along some dimension (~,

more accurate, more timely) or ratings that are of equivalent quality and reputation but at 

a lower price. 

46 See Senate Report, 109-326, p. 1. 47 See Senate Report, 109-326, p. 7. 

18
 
Increasing the number of entities that can be treated as NRSROs for purposes of 

laws and regulations using that term, by itself, may not have a significant effect on 

competition. The newer NRSROs, by showing themselves (or causing the long 

established NRSROs) to provide ratings that are superior in either quality or price, could 

create additional competition. As discussed above, because of the importance of 

reputation, the difficulty in establishing a reputation quickly, and other economic factors, 

it may take some time before the impact of increased competition can be observed. 

Gaining acceptance in the market for a new NRSRO may be even more difficult when 

investors and their agents rely upon written policies and procedures requiring the use of 

ratings provided by just two or three of the currently market-dominant NRSROs. 

Altering such policies and procedures would require affirmative actions on the part of 

investors. In addition, while the Rating Agency Act and the Commission's registration 

and oversight program have made it easier for smaller entrants to become NRSROs, 

certain regulations, both in the United States and internationally, only recognize the 

largest credit rating agencies - a subclass ofthe NRSROs.48 

As described above, the provisions of Section 15E(h) of the Exchange Act and 

Rule 17g-5 require NRSROs to establish procedures to manage conflicts ofinterest, to 

disclose applicable conflicts of interest, and prohibit them from having certain conflicts 

of interest.l'' In the credit rating industry, conflicts of interest may arise from a number of 

activities, including the manner of compensation, the provision of consulting or advisory 

services, and business relationships and affiliations. Reducing the barriers to entry in the 

market for providing NRSRO ratings and, hence increasing competition, may, in fact, 

reduce conflicts of interest in substantive ways. This market disciplining mechanism will 

be less effective the more difficult it is for investors to determine the true credit quality of 

the rated debt security or obligor. 

F. User Perspectives 

On April 15, 2009, the Commission held a roundtable relating to its oversight of 

credit rating agencies. Discussion topics included issues related to recent SEC rulemaking 

initiatives, such as conflicts of interest, competition, and transparency. Roundtable 

participants included leaders from investor organizations, financial services associations, 

government agencies, credit rating agencies, and academia. Some of the proposals by 

roundtable participants included: 

•	 Establish an independent credit rating agency oversight board with authority not 

only over the substance of the ratings process, conflicts, disclosure and pay, but 

also the transition away from regulatory reliance on ratings. 50 

48 See June 2009 Joint Forum Report.
 49 See 15 U.S.C 78o-7(h) and 17 CFR240.17g-5.
 50 See letter from Frank Partnoy, George E. Barrett Professor of Law and Finance, University of San
 

Diego School of Law, San Diego, California, (File No. 4-579), dated April 15, 2009, ("Partnoy 

Letter"). 

19
 
51 

52 

53 

54 

55 

56 

• Establish a credit rating review board that would have to sign off on any rating 

before it took on regulatory significance or, alternatively, which would audit 

ratings after the fact to ensure rating agencies are sufficiently disclosing 

methodologies, the rating agencies' methodologies are sound and rating agencies 

are adhering to them." 

• Implement a model similar in nature to a utility where a small transaction fee 

would be instituted to support ratings. 52 

• A group ofmajor institutional investors should set up their own rating agency, 

capitalized and paid for by the investors, working from their point of view and 

supplied with top talent and technology. 53 

• Require every rating provided by an NRSRO paid by the issuer be accompanied 

by a rating provided by an Investor Owned and Controlled Rating Agency 

(IOCRA) that is also paid for by the issuer. IOCRAs would be owned and 

operated by the largest, most sophisticated debt market investors. 54 

• Introduce a new compensation model where investors would choose which rating 

agencies are paid for ratings. In one alternative, initial rating fees would be 

deducted from proceeds of a new issue and directed to rating agencies by the 

buyer/owner ofthe bonds. Each investor would "designate" their pro rata portion 

of fees to one or more rating agencies. Any licensed rating agency would be 

eligible to rate a bond and the issuer would be required to provide all interested 

rating agencies with the information to rate their securities. Maintenance rating 

fees would be paid by the issuer along with coupon/amortization payments." 

• Require issuers to obtain a rating from a new entrant for every rating obtained 

from a long established NRSRO. 56 

• Require issuers to rotate the rating agency they use to provide their ratings every 

three years - analogous to the rotation process implemented for financial 

auditors. 57 

See letter from Congressional Oversight Panel's Special Report on Regulatory Reform, submitted
 

by Damon Silvers, AFL-CIO, (File No. 4-579), dated April 9, 2009.
 

See letter from James A. Kaitz, President and CEO, The Association for Financial Professionals.
 

(File 4-579), April 15,2009.
 

See letter from Alex 1. Pollock, Resident Fellow, American Enterprise Institute, (File No. 4-579),
 

dated April 15,2009.
 

See letter from Joseph A. Grundfest and Eugenia Petrova, Stanford Law School and The Rock
 

Center on Corporate Governance, (File No. 4-579), dated April 9, 2009.
 

See letter from Mayree Clark and Andrew Jones, (File No. 4-579), dated April 9, 2009.
 

See letter from Ethan Berman, RiskMetrics Group, (File No. 4-579), dated April 15,2009,
 

("Berman Letter").
 

See Berman Letter.
 

20 

57 
•	 Remove NRSROs exemption from misstatements in registration statements in 

section 11 of the Securities Act of 1933 and their exemption from liability as 

experts under Securities Act Rule 436; and adopt legislation indicating that 

NRSROs are subject to private rights of action under specified statutory criteria. 58 

G.	 The Potential Impact on Competition of Newly Proposed NRSRO 

Amendments and Rule 

The Rating Agency Act and the registration and oversight program for NRSROs 

implemented by the Commission in June 2007 under the Act are designed, among other 

things, to promote competition. For example, the registration process prescribed by the 

Rating Agency Act and Rule 17g-1 make it easier for credit rating agencies to become 

NRSROs and, thereby, to compete with long established NRSROs. In addition, the 

disclosure requirements of Form NRSRO make it easier for users of credit ratings to 

compare NRSROs and, therefore, for an NRSRO to distinguish itself from its peers. For 

example, thedisclosure of performance statistics and the methodologies and procedures 

for determining credit ratings make it easier for users to assess the accuracy of an 

NRSRO's credit ratings and how well its procedures and methodologies are designed to 

achieve accuracy. Moreover, the disclosures of conflicts, the procedures for managing 

conflicts, and the procedures for protecting material, nonpublic information allow users 

of credit ratings to assess the steps an NRSRO has taken to ensure the integrity of its 

credit rating processes. 

The new rules adopted by the Commission in February 2009 are designed, among 

other things, to promote competition. For example, under paragraph (d) of Rule 17g-2, as 

amended, NRSROs are required to publicly provide the histories of 10% of their issuerpaid credit ratings, in each class ofratings for which they have issued 500 or more such 

ratings and with a six month grace period. 

In addition the adopted rules prescribe greater specificity with respect to the 

default and ratings transition statistics the NRSROs disclose in Form NRSRO. For 

example, NRSROs are required to calculate these statistics over specific time periods - I, 

3, and 10 years and across the different classes of credit ratings for which they are 

registered - as applicable: (1) financial institutions, brokers, or dealers; (2) insurance 

companies; (3) corporate issuers; (4) issuers of asset-backed securities; and (5) issuers of 

government securities, municipal securities, or sovereign securities. The class of 

government securities must be further separated into three additional classes: sovereigns, 

United States public finance, and international public finance. 

These enhanced disclosures with respect to the performance of the NRSROs' 

credit ratings are designed to foster greater accountability of the NRSROs with respect to 

See letter from Gregory W. Smith, General Counsel, Colorado Public Employees' Retirement 

Association, (File No. 4-579), dated April S, 2009. Also, see Partnoy letter (Partnoy comments 

that rating agencies should not be exempt from securities fraud liability and should not enjoy any 

special privilege over other gatekeepers in Section 11 of the Securities Act of 1933, Regulation 

FD, or elsewhere). 

21 

58 
their credit ratings as well as competition among the NRSROs by making it easier for 

persons to analyze the actual performance of the credit ratings the NRSROs issue in 

terms of accuracy in assessing creditworthiness. Ultimately, this could make it easier for 

a smaller, newer NRSRO to demonstrate that it has a superior credit rating methodology 

and, thereby, enhance its reputation for issuing accurate ratings. 

VI. COMMISSION'S VIEW ON TRANSPARENCY 

One of the goals of the Rating Agency Act is to increase transparency in the credit 

rating industry. As discussed above, the provisions of Section 15E of the Exchange Act 

and Rule 17g-1 require NRSROs to publicly disclose their Form NRSROs and Exhibits 1 

through 9, which contain information about their performance statistics; procedures and 

methodologies for determining credit ratings; procedures to prevent the misuse of 

material, non-public information; their organizational structure; their code of ethics (or 

explanation ofwhy they do not have a code of ethics); their conflicts ofinterest; their 

procedures to manage conflicts ofinterest; information about their credit analysts; and 

information about their designated compliance officers. Prior to the implementation of 

the NRSRO registration and oversight program, certain credit rating agencies disclosed 

some ofthis information, particularly with respect to credit rating performance statistics 

and their procedures and methodologies for determining credit ratings. The NRSRO 

oversight program has increased the amount of information disclosed and concentrated 

the disclosure in a single location: Form NRSRO. The following is a list of the Internet 

Web site links where the Form NRSRO for each credit rating agency registered as an 

NRSRO currently can be obtainedr'" 

A.M. Best Company, Inc.
 

http://www.ambest.com/nrsro/formnrsro.pdf
 

DBRS Ltd.
 

http://www.dbrs.com/intnlweb/jsp/search/listResults.faces
 

Egan-Jones Rating Company 

http://www.egan-jones.com/publicdocs/Form%20NRSRO%20Nov%202007.doc 

Fitch, Inc. 

http://www.fitchratings.com/jsp/corporate/PolicyRegulation.faces?context=3&det 

ail=4 

Japan Credit Rating Agency, Ltd.
 

http://www.jcr.co.jp/english/nrsro/index.html
 

LACE Financial Corp.
 

http://www.lacefinancial.com/Out/documents/Disclosure.pdf
 

Moody's Investors Service, Inc. 

These are the Internet Web site addresses as of June 2009. The addresses may change over time. 

22
 

59 
http://www.moodys.com/cust/content/loadcontent.aspx?source=staticcontent/Free 

%20Pages/Regulatory%20Affairs/NRSRO.htm 

Rating and Investment Information, Inc.
 

http://www.r-i.co.jp/englratinglnrsro/nrsro.html
 

Realpoint LLC
 

http://www.realpoint/ComplianceDocuments/NRSRO.pdf.
 

Standard & Poor's Ratings Services 

http://www2.standardandpoors.com/portal!sitelsp/en/us/page. topic/ratings nrsro/2 

,1,1,6,0,0,0,0,0,0,0,0,0,0,0,0.html 

The Commission believes that the requirement to make these disclosures has 

enhanced the transparency ofthe credit rating industry but that such transparency could 

still be enhanced further. Consequently, the amendments to the NRSRO rules adopted by 

the Commission on in February 2009 contain a number of new requirements designed to 

further increase the transparency ofthe credit rating processes ofthe NRSROs. The 

amendments to Exhibit 2 to Form NRSRO proposed by the Commission are designed to 

enhance the quality ofthe disclosures NRSROs make about their procedures and 

methodologies for determining credit ratings. The first adopted amendment requires an 

NRSRO to disclose whether it considers in its rating process for structured finance 

products steps taken to verify information about the assets in the pool backing the 

structured finance products. Underwriters and sponsors of structured finance products 

frequently take some steps to verify information provided by borrowers in loan 

documentation. Generally, they have been reluctant to provide the results ofthis 

verification to NRSROs for proprietary reasons. The amendment would not require that 

the NRSROs incorporate verification (or the lack of verification) into their ratings 

processes. Rather, it would require an NRSRO to disclose whether and, if so, how 

information about verification performed on the assets is relied on in determining credit 

ratings for structured finance products. For example, an NRSRO would need to disclose, 

as applicable: if it does not consider steps taken to verify the information; if it requires 

some minimum level of verification to be performed before it will determine a credit 

rating for a structured finance product; and how it incorporates the level of verification 

performed into its procedures and methodologies for determining credit ratings (~, if it 

compensates for the lack ofverification by requiring greater levels of credit enhancement 

for the tranche securities). 

The Commission believes this disclosure will benefit users of credit ratings by 

providing information about the potential accuracy of an NRSRO's credit ratings. The 

NRSROs determine credit ratings for structured finance products based on assumptions 

in their models as to how the assets underlying the instruments will perform under 

varying levels of stress. These assumptions are based on the characteristics of the assets 

(~, value ofthe property, income of the borrower) as reported by the arranger ofthe 

structured finance product. If this information is inaccurate, the capacity of the model to 

predict the potential future performance ofthe assets may be significantly impaired. 

23
 
Consequently, information about whether an NRSRO requires that some level of 

verification be performed or takes other steps to account for the lack of verification or a 

low level of verification would be useful to users of credit ratings in assessing the 

potential for an NRSRO's credit ratings to be adversely impacted by bad information 

about the assets underlying a rated structured finance product. 

The second amendment requires an NRSRO to disclose whether it considers 

qualitative assessments ofthe originator of assets underlying a structured finance product 

in the rating process for such products. Certain qualities of an asset originator, such as its 

experience and underwriting standards, may impact the quality of the loans it originates 

and the accuracy ofthe associated loan documentation. This, in tum, could influence 

how the assets ultimately perform and the ability of the NRSRO's models to predict their 

performance. Consequently, the failure to perform any assessment ofthe loan originators 

could increase the risk that an NRSRO's credit ratings may not be accurate. Therefore, 

disclosures as to whether the NRSRO performs any qualitative assessments of the 

originators would be useful in comparing the efficacy of the NRSRO's procedures and 

methodologies. 

The third amendment requires an NRSRO to disclose the frequency ofits 

surveillance efforts and how changes to its quantitative and qualitative ratings models are 

incorporated into the surveillance process. The goal is to provide to users of credit 

ratings information that would be useful in comparing the ratings methodologies of 

different NRSROs. For example, how often and with what models an NRSRO monitors 

its credit ratings would be relevant to assessing the accuracy of the ratings insomuch as 

ratings based on stale information and outdated models may not be as accurate as ratings 

oflike products determined using newer data and models. Moreover, with respect to new 

types of rated obligors and debt securities, the NRSROs refine their models as more 

information about the performance of these obligors and debt securities is observed and 

incorporated into their assumptions. Consequently, as the models evolve based on more 

robust performance data, credit ratings of obligors or debt securities determined using 

older models may be at greater risk for being inaccurate than the newer ratings. 

Therefore, whether the NRSRO verifies the older ratings using the newer methodologies 

would be useful to users of credit ratings in assessing the accuracy ofthe credit ratings. 

Finally, as noted above, under paragraph (d) of Rule l7g-2, as amended, NRSROs 

are required to publicly provide the histories of 10% of their issuer-paid credit ratings, in 

each class of ratings for which they have issued 500 or more such ratings and with a six 

month grace period. The goal is to increase transparency by providing users of credit 

ratings, investors, and other market participants and observers the raw data with which to 

compare how the NRSROs initially rated an obligor or security and, subsequently, 

adjusted those ratings, including the timing of the adjustments. 

VII. COMMISSION'S VIEW ON CONFLICTS OF INTEREST 

There are two business models used in the credit rating industry and each has 

potential inherent conflicts of interest. As discussed above, the business model of the 

24
 
largest NRSROs is to receive compensation from obligors for rating the obligor or 

securities issued by the obligor (the "issuer-pay model"). This issuer-pay model creates a 

potential conflict in that an NRSRO, in order to gain favor with the issuer and retain its 

business, may determine a credit rating that is higher than the NRSRO's objective 

analysis would imply. This conflict potentially could be broader than a single issuer to 

the extent that an NRSRO determines higher credit ratings for a class ofissuers in order 

to retain or attract business across all issuers in that class. 

The other business model is the subscriber-pay model, which also is subject, 

albeit to a potentially lesser degree, to potential conflicts ofinterest. For example, a 

subscriber may hold a securities position (long or short) that potentially could be 

advantaged by an NRSRO upgrading or downgrading the position to the extent such 

rating action caused the market value for the security to increase or decrease. 

Furthermore, a subscriber may want to hold a particular security in an investment 

portfolio but may be constrained from doing so because its credit rating is lower than its 

internal investment guidelines, an applicable contract, or an applicable regulation permit. 

An upgrade ofthe credit rating of the security by the NRSRO could remove this 

impediment to investing in the security. This conflict exists only to the extent that the 

subscriber NRSRO is aware of the portfolio holdings of the subscriber. Moreover, this 

conflict is mitigated to the extent subscribers have different interests with respect to an 

upgrade or downgrade of a particular security. 

The Commission took steps to address the potential conflicts in both business 

models when it adopted the rules implementing the registration and oversight program for 

NRSROs. As discussed above, the approach taken in the rules is to require the disclosure 

in Form NRSRO ofthe general types of conflicts that arise from the NRSRO's business 

activities. Additionally, the Commission prohibited an NRSRO from having certain 

conflicts of interest unless it discloses them and has procedures for managing them, and 

prohibited outright an NRSRO from having certain other conflicts of interest. 

A number of studies have attempted to identify cases of "rating shopping" 

behavior, where, under the "issuer pay" business model, issuers seek to hire rating 

agencies that provide more favorable ratings. For example, according to one study of 

residential mortgage-backed securities transactions in the early to mid 1990s, rating 

agencies whose rating methodologies required lower levels of credit enhancement to 

reach a given rating level than competitors tended to increase their market share. 6oA 

more recent study of corporate ratings concluded that the presence of a new entrant could 

result in more "issuer-friendly" ratings." Other analysts, however, have argued that the 

incentives for a rating agency to maintain its reputation outweigh the short term gain 

which can be achieved by issuing ratings oflower quality.62 

60 See Cantor and Packer (1994).
 61 See Bo Becker and Todd Milbourn, "Reputation and Competition, Evidence from the Credit
 

Rating Industry", Harvard Business School Working Paper 09-051, October 2008. 62 See,~, Steven L. Schwarcz, "Private Ordering of Public Markets: The Rating Agency 

Paradox", University of Illinois Law Review, Vol. 2002, No.2, February 2002 and Daniel M 

Covitz and Paul Harrison, "Testing Conflicts ofInterest at Bond Ratings Agencies with Market 

25 
The potential for conflicts of interest may be particularly acute in the structured 

product area, including RMBS and CDOs among others, where issuers are separate legal 

entities created and operated by a relatively concentrated group ofsponsors, underwriters 

and managers (collectively "arrangers"). These products are highly complex and require 

specific and technical knowledge of financial engineering and valuation of the underlying 

assets. But the complexity of the products and the issuers' ability to control the flow of 

information about the underlying assets may lead to an outcome where one party to the 

transaction, the arranger, has more or better information about the transaction than the 

other party (the investor).63 This informational imbalance, combined with very high 

concentration in NRSRO credit raters, increases the potential for conflicts ofinterest to 

impair market integrity. As discussed above, however, reputational risk provides 

incentives for firms to produce high quality ratings. 

The staff's examinations ofselect credit rating agencies regarding their role in the 

turmoil in the subprime mortgage-related securities markets revealed, among other 

things, that the rating agencies examined appear to have failed to properly manage 

potential conflicts ofinterest.64 Within this report, the staff ofthe Office of Economic 

Analysis ("OEA") noted that the conflicts created from the "issuer pay" model in rating 

structured finance products, particularly RMBS and related-CDOs, may have been 

exacerbated for a number of reasons which are summarized in the following four 

paragraphs. 65 

First, the arranger was often the primary designer of the deal and as such, had 

more flexibility to adjust the deal structure to obtain a desired credit rating as compared 

to arrangers of non-structured asset classes. As well, arrangers that underwrote RMBS 

and CDO offerings had substantial influence over the choice of rating agencies hired to 

rate the deals. 

In addition, there was a high concentration in the firms conducting the 

underwriting function. The combination ofthe arrangers' influence in determining the 

choice ofrating agencies and the high concentration of arrangers with this influence 

appears to have heightened the inherent conflicts ofinterest that exist in the "issuer pay" 

compensation model. 

Pressure from arrangers could have also corne in the form ofrequiring more 

favorable ratings or reduced credit enhancement levels. Such outcomes would reduce the 

cost of the debt for a given level of cash inflows from the asset pool. 

Anticipation: Evidence that Reputation Incentives Dominate", FEDS Working Paper No. 2003­

68, December 2003. 63	 Economists typically refer to this outcome as the existence of information asymmetries. See, ~.,

George A. Akerlof, "The Market for 'Lemons': Quality Uncertainty and the,Market Mechanism", 

Quarterly Journal of Economics 84(3): 488-500, 1970. 64	 See July 2008 Staff Report. 65	 See July 2008 Staff Report, Section V, Observations by the Office of Economic Analysis. 

26
 
Finally, high profit margins from rating RMBS and CDOs may hav~ pro:ided an 

incentive for a rating agency to encourage the arrangers to route future business I~S way 

Unsolicited ratings were not available to provide an independent check on ~he ratmg 

agencies' ratings, and the structures oft~ese securities we~e com~lex, a~d information 

regarding the composition of the portfolio of assets, especially pnor to Issuance was 

difficult to obtain for parties unrelated to the transaction. 

Analysts note that fees for structured finance transactions could, in some cases, 

could be significantly higher than fees for corporate structures ofsimilar size.66 The staff 

examinations revealed that revenues derived from RMBS ratings increased between 2002 

and 2006 by a percentage that varied among these three firms from approximately 100% 

for the firm which had the lowest percentage growth in revenues to over 200% for the 

firm which had the highest percentage growth. For CDOs, during the same period,ratings 

revenue increased by a percentage that varied from approximately 200% for the firm 

which had the lowest percentage growth to over 800% for the firm which had the highest 

h 67 percentage growt . 

During the period covered by the second annual report, the Commission adopted 

amendments to prohibit three additional conflicts of interest outright. The first 

amendment prohibits an NRSRO from issuing a credit rating with respect to an obligor or 

security where the NRSRO, or a person associated with the NRSRO, made 

recommendations to the obligor or the issuer, underwriter, or sponsor ofthe security (that 

is, the parties responsible for structuring the security) about the corporate or le~al

structure, assets, liabilities, or activities of the obligor or issuer of the security. 8 This 

rule prohibits the NRSRO and, in particular, its credit analysts from making 

recommendations to obligors, issuers, underwriters, and sponsors such as arrangers of 

structured finance products about how to obtain a desired credit rating during the rating 

process. It also prohibits an NRSRO from issuing a credit rating where a person 

associated with the NRSRO, such as an affiliate, made such recommendations. 

The second amendment prohibits the conflict ofinterest that arises when a fee 

paid for a rating is discussed or arranged by a person within the NRSRO who has 

responsibility for participating in determining credit ratings (including analysts and rating 

committee members) or for developing or approving procedures or methodologies used 

for determining credit ratings, including qualitative and quantitative models.69 This 

proposal is designed to effectuate the separation within the NRSRO ofpersons involved 

in fee discussions from persons involved in the credit rating analytical process. The 

incentives ofthe persons discussing fees could be based primarily on generating revenues 

for the NRSRO; whereas the incentives ofthe persons involved in the analytical process 

should be based on determining accurate credit ratings. There is a significant potential 

for these distinct incentive structures to conflict with one another where persons within 

the NRSRO are engaged in both activities. 

66 See, ~, Fons (2008).
 67 See July 2008 Staff Report.
 68 Se~ February 2,2009 Adopting Release, 17 CFR 240. 17g-5(c)(5).
 69 See February 2, 2009 Adopting Release, 17 CFR 240.17g-5(c)(6).
 

27 
The potential consequences are that a credit analyst or person responsible for 

approving credit ratings or credit rating methodologies could, in the context of 

negotiating fees, let business considerations undermine the objectivity ofthe credit rating 

process. For example, an individual involved in a fee negotiation with an issuer might 

not be impartial when it comes to rating the issuer's securities. In addition, persons 

involved in approving the methodologies and processes used to determine credit ratings 

could be reluctant to adjust a model to make it more conservative if doing so would make 

it more difficult to negotiate fees with issuers. For these reasons, the Commission 

believes that this conflict should be prohibited. 

The third amendment prohibits the conflict of interest relating to the issuance or 

maintenance of a credit rating where a credit analyst who participated in determining or 

monitoring the credit rating, or a person responsible for approving the credit rating, 

received gifts, including entertainment, from the obligor being rated, or from the issuer, 

underwriter, or sponsor ofthe securities being rated, other than items provided in the 

context ofnormal business activities that have an aggregate value ofmore than $25.70 

Persons seeking credit ratings for an obligor or debt security could use gifts to gain favor 

with the analyst responsible for determining the credit ratings and cause the analyst to be 

less objective during the credit rating process. In the case of a substantial gift, the 

potential to impact the analyst's objectivity could be immediate. With smaller gifts, the 

danger is that over time the cumulative effect of repeated gifts can impact the analyst's 

objectivity. Therefore, the amendment establishes an absolute prohibition on gifts with 

the exception of minor incidentals provided in business meetings. 

VIII. CONCLUSION 

As described above, the Commission took a number of actions during the year 

with respect to NRSROs. In the coming year, the Commission will continue to review 

NRSRO issues through its oversight function, including staff examinations of the 

NRSROs, and expects to consider whether to adopt any additional rules after a full 

consideration of all comments received. 

See February 2,2009 Adopting Release, 17 CFR 240. 17g-5(c)(7). 

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