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23–047 PDF 2005

REFORMING CREDIT RATING AGENCIES:

THE SEC’S NEED FOR STATUTORY

AUTHORITY

HEARING

BEFORE THE

SUBCOMMITTEE ON 

CAPITAL MARKETS, INSURANCE AND 

GOVERNMENT SPONSORED ENTEREPRISES

OF THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

APRIL 12, 2005

Printed for the use of the Committee on Financial Services

Serial No. 109–14

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES 

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa 

RICHARD H. BAKER, Louisiana 

DEBORAH PRYCE, Ohio 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

ROBERT W. NEY, Ohio 

SUE W. KELLY, New York, Vice Chair 

RON PAUL, Texas 

PAUL E. GILLMOR, Ohio 

JIM RYUN, Kansas 

STEVEN C. LATOURETTE, Ohio 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, JR., North Carolina 

JUDY BIGGERT, Illinois 

CHRISTOPHER SHAYS, Connecticut 

VITO FOSSELLA, New York 

GARY G. MILLER, California 

PATRICK J. TIBERI, Ohio 

MARK R. KENNEDY, Minnesota 

TOM FEENEY, Florida 

JEB HENSARLING, Texas 

SCOTT GARRETT, New Jersey 

GINNY BROWN-WAITE, Florida 

J. GRESHAM BARRETT, South Carolina 

KATHERINE HARRIS, Florida 

RICK RENZI, Arizona 

JIM GERLACH, Pennsylvania 

STEVAN PEARCE, New Mexico 

RANDY NEUGEBAUER, Texas 

TOM PRICE, Georgia 

MICHAEL G. FITZPATRICK, Pennsylvania 

GEOFF DAVIS, Kentucky 

PATRICK T. MCHENRY, North Carolina 

BARNEY FRANK, Massachusetts 

PAUL E. KANJORSKI, Pennsylvania 

MAXINE WATERS, California 

CAROLYN B. MALONEY, New York 

LUIS V. GUTIERREZ, Illinois 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

JULIA CARSON, Indiana 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

BARBARA LEE, California 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

JOSEPH CROWLEY, New York 

WM. LACY CLAY, Missouri 

STEVE ISRAEL, New York 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

ARTUR DAVIS, Alabama 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

MELISSA L. BEAN, Illinois 

DEBBIE WASSERMAN SCHULTZ, Florida 

GWEN MOORE, Wisconsin, 

BERNARD SANDERS, Vermont

Robert U. Foster, III, Staff Director 

(III)

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE AND GOVERNMENT SPONSORED

ENTERPRISES

RICHARD H. BAKER, Louisiana, Chairman

JIM RYUN, Kansas, Vice Chair 

CHRISTOPHER SHAYS, Connecticut 

PAUL E. GILLMOR, Ohio 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

FRANK D. LUCAS, Oklahoma 

DONALD A. MANZULLO, Illinois 

EDWARD R. ROYCE, California 

SUE W. KELLY, New York 

ROBERT W. NEY, Ohio 

VITO FOSSELLA, New York, 

JUDY BIGGERT, Illinois 

GARY G. MILLER, California 

MARK R. KENNEDY, Minnesota 

PATRICK J. TIBERI, Ohio 

J. GRESHAM BARRETT, South Carolina 

GINNY BROWN-WAITE, Florida 

TOM FEENEY, Florida 

JIM GERLACH, Pennsylvania 

KATHERINE HARRIS, Florida 

JEB HENSARLING, Texas 

RICK RENZI, Arizona 

GEOFF DAVIS, Kentucky 

MICHAEL G. FITZPATRICK, Pennsylvania 

MICHAEL G. OXLEY, Ohio 

PAUL E. KANJORSKI, Pennsylvania 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

JOSEPH CROWLEY, New York 

STEVE ISRAEL, New York 

WM. LACY CLAY, Missouri 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

ARTUR DAVIS, Alabama 

MELISSA L. BEAN, Illinois 

DEBBIE WASSERMAN SCHULTZ, Florida 

BARNEY FRANK, Massachusetts 

(V)

C O N T E N T S 

Page 

Hearing held on: 

April 12, 2005 ................................................................................................... 1

Appendix: 

April 12, 2005 ................................................................................................... 23

WITNESS 

TUESDAY, APRIL 12, 2005

Nazareth, Annette, Director of Market Regulation, United States Securities 

and Exchange Commission .................................................................................. 4

APPENDIX 

Prepared statements: 

Oxley, Hon. Michael G. .................................................................................... 24

Fitzpatrick, Hon. Michael G. ........................................................................... 26

Gillmor, Hon. Paul E. ....................................................................................... 27

Kanjorski, Hon. Paul E. ................................................................................... 28

Nazareth, Annette ............................................................................................ 30

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Kanjorski, Hon. Paul E.: 

Written letter to Hon. William H. Donaldson, Chairman, U.S. Securities 

and Exchange Commission, April 12, 2005 ................................................ 39

(1)

REFORMING CREDIT RATING AGENCIES: 

THE SEC’S NEED FOR STATUTORY 

AUTHORITY 

Tuesday, April 12, 2005

U.S. HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE, 

AND GOVERNMENT SPONSORED ENTERPRISES, 

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The subcommittee met, pursuant to call, at 2:05 p.m., in Room 

2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding. 

Present: Representatives Baker, Ryun, Kelly, Brown-Waite, 

Hensarling, Kanjorski, and Wasserman Schultz. 

Chairman BAKER. [Presiding.] I would like to call this meeting 

of the Capital Markets Subcommittee to order. 

Today, the committee meets for the purpose of receipt of testimony from Annette Nazareth, who is the director of the Divsion of 

Market Regulation of the U.S. Securities and Exchange Commission. 

The committee has had for some number of years interest in and 

perhaps concern for the manner by which rating agencies are regulated and overseen in their function, consistent with the requirements of the Investment Company Act, which when a public operating company chooses to issue debt and enter the public markets, 

must receive at least two ratings from independent rating agencies 

for that debt to be properly issued. That, of course, sets in motion 

a number of concerns as to the independence and insightfulness of 

the agencies which are charged with the responsibility to conduct 

these ratings. 

A brief summary of our history and how we arrive at our hearing 

today, it was in 1994 that the SEC first established the nationally 

recognized credit rating agency definition and left unclear exactly 

what it was required of an entity to become an NRSRO. Subsequent to the 1994 establishment of that principle, in 1997 the agency issued a subsequent release which was not adopted because of 

opinions issued in writing by the Department of Justice indicating 

that the standards attempting to be established would prohibit, in 

all likelihood, entry into the market or make it substantially difficult so that there would not be an ability of competitors to enter 

into the rating agency business. 

In 2003, the SEC issued another release posing 54 questions for 

public comment. A number of issues were raised as a result of 

2

those responses and yet no action of a substantive form was taken 

at that time. A rule is now pending issued by the SEC which is 

making the attempt, as I view it, to redefine what constructs the 

elements of an NRSRO. There are three specific items listed, but 

unfortunately I have come to the conclusion that those elements 

are not sufficiently different or unique from the understandings 

originally posed by the term ‘‘NRSRO.’’

Subsequently to the 2003 questions issued to stakeholders and 

the number of issues raised in that release and public comment period, I consider the current rule to be inadequate in scope and in 

content. In order to make the point of our concerns, there is publicly disclosed information by one rating agency on its financials 

and in the year 2004 enjoyed an unbelievable 690 percent return 

on equity. I know of no other public operating company that is even 

close. While more remarkably, the other principal agency engaged 

in the market does not even disclose its financials at all. 

Further, there has been neither establishment of nor disclosure 

of the methodologies by which a rating agency enters into a corporation and comes to its ratings determinations. That remains unclear. The ability to rate a public operating company without being 

requested by that company, and of course subsequently sending the 

company an invoice, presents some clear ethical question, at least 

in my mind, that needs to be addressed. 

In summary, I feel that the rating agencies are somewhat of 

mystical anointed monopoly, not unlike our good friends Fannie 

and Freddie, but with even less accountability. I hope today in the 

course of our questions and answers with Ms. Nazareth to be able 

to come to a better understanding of what action, if any, the Congress should take in assisting the SEC to come to final resolution 

on all these matters of public importance. 

Mr. Kanjorski? 

Mr. KANJORSKI. Thank you, Mr. Chairman. 

We meet for the third time in the last 2 years to explore the 

issue of regulating credit rating agencies. As I have regularly noted 

during the past examinations, entities like Moody’s, Standard and 

Poor’s, and Fitch have long published their views on the credit worthiness of issuers of debt securities. The significance of these opinions has also greatly expanded in recent years as a result of increases in the number of issues and issuers, the globalization of our 

financial markets, and the introduction of complex financial products. 

Although rating agencies received some scrutiny after the recent 

surge of corporate scandals, we have not yet mandated any substantive changes in their practices. One witness at one of our past 

hearings nevertheless noted that the agencies ‘‘played a significant 

role’’ in Enron’s failure. A Senate investigative report also determined that the monitoring and review of Enron’s finances ‘‘fell far 

below the careful efforts one would have expected from organizations whose ratings hold so much importance.’’

Outside Enron’s auditors, the rating agencies probably had the 

greatest access to non-public information about the firm’s complicated financial arrangements. Even with this data, the agencies 

exhibited a disappointing reliability in the accuracy of their coverage. In fact, the three existing nationally recognized statistical 

3

rating organizations at the time of Enron’s failure, rated the company at investment-grade until 4 days before its bankruptcy filing. 

The failure of the nationally recognized agencies to lower their 

credit ratings in a timely manner in this case and other instances 

such as the WorldCom bankruptcy, New York City’s debt crisis, 

Washington Public Power Supply System’s default, and Orange 

County’s collapse has resulted in great financial losses for many 

Americans who little understood the true credit risks of their investments. 

This issue is therefore one on which we should focus our attention in the 109th Congress. During our past hearings, it has also 

become increasingly clear to me that while our capital markets and 

the rating industry have evolved considerably in recent years, the 

Commission’s rules in this area have changed little, even though 

it has studied these issues for more than a decade. Additionally, 

The Washington Post late last year in a series of investigative reports on credit ratings concluded that although the agencies with 

national recognition are the gatekeepers of capitalism, they have 

no commensurate oversight or accountability. 

The regulation of rating agencies, I believe, is ripe for examination and action. I know that the Securities and Exchange Commission agrees. Today’s witness, Annette Nazareth, the Commission’s 

Director of Market Regulation, has previously observed that while 

rating agencies have generally performed their work well for nearly 

a century, they have also missed some colossal failures in recent 

years. She has further described our debt markets as the dark corner of the securities industry. The time has come to shine some 

light into this dimly lit field. 

Accordingly, I was pleased that the Commission recently and finally put forward for public comment a proposed rule to define 

what constitutes a nationally recognized statistical rating organization and the process for making such a designation. While this proposal is a good step, more still needs to be done in the area of rating agency oversight. The agencies, as I am aware, are also working with the Commission to establish a voluntary framework to improve transparency. 

While some hope that this agreement will be effective, many 

have lingering doubts. After all, Chairman Donaldson has already 

indicated that he does not have the confidence that these discussions will result in substantive reforms because the existing agencies with national recognition have taken the position that they 

will not allow the Commission to conduct inspections or take enforcement actions. 

As you know, Mr. Chairman, top officials at the Commission 

have also regularly suggested that additional legislative authority 

may be needed in the area of rating agencies. Consequently, I have 

come to conclude that it is time for us to ask the Commission what 

specific authorities it believes it needs to effectively oversee rating 

agencies. I will therefore be sending a letter to the Commission 

after today’s hearing to request this technical assistance. The Congress will ultimately decide whether to consider a bill related to 

these issues, but obtaining the insights of the experts at the Commission will help us in crafting an appropriately balanced piece of 

legislation that addresses First Amendment concerns. 

4

Learning of the Commission’s views now on the needed statutory 

authority will also help us to expedite future action if the voluntary 

framework negotiations break down or result in a flawed product. 

In closing, Mr. Chairman, we must act to ensure the continued 

integrity of the rating agencies and the credit rating process. I also 

look forward to hearing from our witness today and to moving forward prudently and promptly on these important matters. 

[The prepared statement of Hon. Paul E. Kanjorski can be found 

on page 28 in the appendix.] 

Chairman BAKER. I thank the gentleman. 

I am advised that no other member desires to make an opening 

statement at this time, but all members’ statements, if submitted, 

will be made part of the official record. 

At this time, I would like to recognize Ms. Annette Nazareth, Director, Division of Market Regulation. 

Your official statement will be made part of the record. Please 

proceed at your leisure, and welcome. 

STATEMENT OF ANNETTE NAZARETH, DIRECTOR, DIVISION 

OF MARKET REGULATION, UNITED STATES SECURITIES AND 

EXCHANGE COMMISSION 

Ms. NAZARETH. Thank you, Chairman Baker, Ranking Member 

Kanjorski and members of the subcommittee. Thank you for the opportunity to testify before you today on behalf of the Securities and 

Exchange Commission. 

Today, I plan to provide you with an overview of the SEC’s recent work concerning credit rating agencies. I will begin with a 

brief history of the SEC’s involvement in this area and then I will 

discuss recent SEC initiatives regarding credit rating agencies. 

Since 1975, the SEC has relied on credit ratings by market-recognized rating agencies for distinguishing among grades of credit 

worthiness in various rules under the federal securities laws. These 

nationally recognized statistical rating organizations, or NRSROs, 

have received no-action letters from the SEC staff. To date, nine 

firms have received such no-action letters. However, during the 

1990s, several NRSROs consolidated so that there are currently 

five such NRSROs: A.M. Best Company, Dominion Bond Rating 

Service, Limited, Fitch, Inc., Moody’s Investor Service, Inc., and 

Standard and Poor’s Division of McGraw Hill Companies, Inc. 

The term ‘‘NRSRO’’ was originally adopted by the Commission 

solely for determining capital charges on different grades of debt 

securities under the Commission’s net capital rule for broker-dealers. Over time, however, the NRSRO concept has been incorporated 

into a number of additional SEC rules and regulations, including 

rules issued under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. 

Congress also has used the NRSRO concept in legislation, as 

have other regulatory bodies including banking regulators both at 

home and abroad. During the past few years, the Commission has 

pursued several approaches on its own and at the direction of Congress to conduct a thorough and meaningful study of credit rating 

agencies and the use of credit ratings under the federal securities 

laws. For example, approximately 2 years ago, the SEC responded 

to a congressional directive under the Sarbanes-Oxley Act of 2002 

5

by issuing a report on the role of credit rating agencies in the securities markets. 

To assist in preparing the report, the SEC held 2 full days of 

public hearings. Hearing participants included representatives 

from credit rating agencies, broker-dealers, buy-side firms, issuers 

and the academic community. The Sarbanes-Oxley report identified 

a number of substantive issues that the Commission planned to explore in more depth, including improved information flow in the 

credit rating process, potential conflicts of interest, alleged anticompetitive or unfair practices, potential regulatory barriers to 

entry in the credit rating business, and ongoing regulatory oversight of credit rating agencies. 

On June 4, 2003, the SEC issued a concept release seeking public 

comment on the issues raised in the Sarbanes-Oxley report. Generally, the SEC sought comment on whether credit ratings should 

continue to be used for regulatory purposes under the federal securities laws and if so, the process of determining whose credit ratings should be used. The Commission also sought comment on the 

appropriate level of oversight that should be applied to credit rating agencies. 

Forty-six commenters responded to the concept release. Most of 

the 46 commenters supported retention of the NRSRO concept. 

Many represented that eliminating the concept would be disruptive 

to the capital markets and would be costly and complicated to replace. Only four commenters supported elimination of the concept 

and there was very little discussion of regulatory alternatives. 

Generally, commenters supported improving the clarity of the 

process for identifying NRSROs to the extent credit ratings continued to be relied upon by the Commission in its rules and regulations. Specifically, commenters generally supported the Commission’s suggestions to specify in more detail what credit rating agencies need to provide to obtain an NRSRO no-action letter. With respect to ongoing oversight, a number of commenters recommended 

that the Commission enhance the staff’s ability to verify whether 

an NRSRO continues to meet the minimum standards that led to 

its designation. 

However, a number of commenters, including each of the current 

NRSROs, also raised concerns about the extent of the Commission’s 

authority to impose requirements on NRSROs. These commenters 

argued that the SEC does not have explicit regulatory authority 

over NRSROs and that NRSRO rating activities are journalistic 

and are afforded a high level of protection under the First Amendment. 

More recently, the Commission on March 3, 2005 voted to issue 

a rule proposal that would define the term ‘‘NRSRO’’ for purposes 

of commission rules. The proposal builds on earlier commission 

work relating to the credit rating agencies. The goal of the proposal 

is to provide greater clarity and transparency to the process of determining whether a credit rating agency’s ratings should be relied 

on as NRSRO ratings for purposes of commission rules. 

The proposed definition and the interpretations thereof are intended to provide credit rating agencies with a better understanding of whether they qualify as an NRSRO. The proposed definition of the term ‘‘NRSRO’’ is composed of three components 

6

which the Commission believes to be the most important criteria 

in determining whether an entity’s ratings should be relied upon 

for purpose of commission rules and regulations. 

Specifically, the Commission is proposing to define the term as 

an entity that issues publicly available credit ratings that are current assessments of the credit worthiness of obligors with respect 

to specific securities or money market instruments; that is generally accepted in the financial markets as an issuer of credible and 

reliable ratings, including ratings for a particular industry or geographic segment by the predominant users of securities ratings; 

and finally, uses systematic procedures designed to ensure credible 

and reliable ratings, manage potential conflicts of interest, and prevent the misuse of non-public information and has sufficient financial resources to ensure compliance with these procedures. These 

three components are described in more detail in my written testimony. 

The rule proposal also states the belief that while adopting a definition of NRSRO would help address commenter concerns regarding transparency, credit rating agencies might desire to continue to 

seek no-action letters in order to clarify the ability of third parties 

to rely on their ratings for regulatory purposes. As such and in 

light of the longstanding reliance by broker-dealers, issuers, investors and others on the existing staff no-action process, the Commission states in the proposal that if it were to adopt a definition of 

NRSRO, it plans to continue to make commission staff available to 

provide no-action letters as appropriate to those entities that 

choose to seek it. No-action letters would be granted for a specific 

period of time, after which the relief would need to be reconsidered. 

As I mentioned previously, a number of commenters to the 2003 

concept release recommended that the Commission enhance the 

staff’s ability to verify whether an NRSRO continues to meet the 

minimum standards that led to its designation. Due to apparent 

limits on the Commission’s authority in this area, the Commission 

staff has worked with the current NRSROs during the past 6 

months to craft a framework for voluntary oversight by the Commission. At this time, our dialogue with the industry has not resulted in an agreed upon voluntary oversight framework. 

Nonetheless, I believe a strong and effective industry-led regime 

could prove to be a constructive and reasonable approach to address a number of concerns involving the credit rating industry 

that have been raised in recent years by Congress, the Commission 

and others such as the International Organization of Securities 

Commissions. 

That said, the Commission believes that to conduct a rigorous 

program of NRSRO oversight, more explicit regulatory authority 

from Congress is necessary. The Commission has not taken a formal position on whether additional legislation should be forthcoming, but it does believe that congressional hearings on this 

issue are useful to ensure that this important question is properly 

vetted. A well thought-out regulatory regime could provide significant benefits in such cases as recordkeeping and addressing conflicts of interest in the industry. 

As Chairman Donaldson said last month before the Senate Committee on Banking, Housing and Urban Affairs, the Commission 

7

welcomes congressional attention and of course would stand ready 

to work with Congress on crafting appropriate legislation if Congress determines such legislation is necessary. 

Thank you for inviting me to testify. I welcome any questions. 

[The prepared statement of Annette Nazareth can be found on 

page 30 in the appendix.] 

Chairman BAKER. Thank you very much, Ms. Nazareth. 

I really want to start with your conclusions reached. In Sarbanes-Oxley, there were a specific litany of, I will list them as concerns or subjects to explore, which you made reference to in your 

remarks. It would seem that the current definition discussion by 

the SEC relative to what constitutes an NRSRO really focuses on 

one of those points raised in the Sarbanes-Oxley recitation, which 

is the potential regulatory barrier to entry into the market. 

However, the other four principal points, conflicts of interest, 

anticompetitive or unfair practices, regulatory oversight, would 

seem to fall in the area that you made reference to in your concluding remarks that may be outside the scope of current authority 

of the agency requiring going forward some legislative action. Is 

that a fair conclusion to reach from your comments? 

Ms. NAZARETH. Yes. Basically, we have the authority to use the 

term in our rules and to define what the term meant. But as you 

pointed out in your statement, this is a very important area and 

one where people have become very reliant on this term. As a result, we believe that it is important to not only determine that a 

credit rating agency has met the terms of the definition at the outset when the no-action letter is issued, but also that it continue on 

an ongoing basis to meet that definition. 

In order to do that effectively, one would at the very minimum 

need a voluntary framework to be able to oversee the process and 

to ensure that those conditions continue to be met or have a more 

rigorous oversight program through legislative authority which 

would give us the ability to require recordkeeping and examinations and other things that are more akin to what a full regulatory 

program would entail. 

Chairman BAKER. Assume for the moment that we enter into a 

voluntary agreement. I have some familiarity with voluntary agreements with other enterprises. If they then choose not to comply, 

the penalties are some adverse market reaction or litigation over 

the terms of the contract, which would seem to me to put the regulator in a very deficient posture. 

What I am proposing is that if we can identify the areas beyond 

the definition of NRSRO, that currently are not within your enforcement authority, I would be very interested in a statutory 

framework enabling the regulator to take on at least as a minimum 

scope those five points identified in Sarbanes-Oxley because that 

did pass the scrutiny of the committee, voted on by the Congress. 

There should not be debate that those five points are good public 

policy to implement. You would not, I take it, see that as an inappropriate thing for the committee to pursue. 

Ms. NAZARETH. No, not at all. 

Chairman BAKER. As to the proposed definition that is now pending, it basically requires that the entity making application for admission issue publicly available ratings, is generally accepted in 

8

the market as an issuer of reliable ratings, and uses systematic 

procedures. I am not sure I understand how those three elements 

constitute something different from what has been historic practice. 

Even though we talk about ‘‘nationally recognized’’ as being the 

art term, when the Commission reviews applicants’ requests for approval, it is that you have to be in the business of credit ratings. 

You have to be viewed as a credible person or entity giving good 

information out. Obviously, you have to have some process to arrive 

at a rating. 

So I am having a little trouble understanding how this threepronged approach is significantly structurally different from the 

current NRSRO requirement. Can you enlighten me on what you 

think is the distinction? 

Ms. NAZARETH. It is not dramatically different. You are correct. 

I think after all of this analysis and the hearings and the comments that we analyzed, it was clear that while there are some 

concerns about competitive impact, the strong majority of opinion 

was that this is a process that the marketplace has come to rely 

upon and that there would be great market disruption to abandon 

this process entirely. 

That having been said, I think that we were looking to improve 

the current situation. So what we did was, this is the first time we 

have actually defined the term, which adds greater transparency, 

makes it easier for new entrants to understand what they will have 

to evidence in order to obtain a no-action letter. We also did try to 

be somewhat broader in the scope of the entities that we would recognize under the definition. 

So for example, for the first time we made it very clear that you 

could be nationally recognized even if your expertise was in a limited sector, either geographically or by topic, that you did not have 

to be nationally recognized as in everybody was using you for all 

purposes. So we have tried to find other ways to address some of 

the competitive concerns. So in that respect, it is a little bit different, but again we were hoping that the transparency of the definition would also make it somewhat easier to apply and might encourage others to apply. 

Chairman BAKER. My time is out, but I am going to ask one 

more, and given the fact that we have other members, try to keep 

it within reasonable time constraints. The definition says that the 

entity making application must have a systemic process by which 

its ratings are achieved. 

Ms. NAZARETH. Yes. 

Chairman BAKER. Does Standard and Poor’s have some systemic 

process they publicly disclose as to how they go about their rating 

process? 

Ms. NAZARETH. I believe that each of the NRSROs does have internal processes that they follow in order to issue credit ratings. 

Chairman BAKER. But they are not necessarily the same? They 

are not necessarily disclosed to the person who is being reviewed? 

In other words, if I am the business guy and I want a rating, I 

would like to know what is it you are going to need to know so I 

can prepare when you knock on the door. What is worse is when 

you show up unannounced and do it to me anyway, but that is another point. 

9

Ms. NAZARETH. Yes, which is another problem. I do think that 

they do endeavor to apply consistent policies and procedures across 

whatever sectors they are covering. I believe that they make it 

clear to the entities that they are rating what it is that the entities 

will need to evidence to them. A number of their procedures, including their conflicts procedures and the like, actually they do 

publish and are on their Web sites. We think it is very important 

that there not only be rigorous procedures, but that they be uniformly followed. Obviously, it would be problematic if they had certain high standards for rating some entities and then did not apply 

those standards to others. It is a critical issue. 

Chairman BAKER. Just a quick follow-on, then. If I were to request of you help secure for the committee S&P, Moody’s, Fitch, the 

other two entities, their systematic review of just financial service 

entities. Let’s just make it just banks. That we should expect each 

of those systematic reviews to be somewhat comparable and similar? 

Ms. NAZARETH. That is their role, that they should be comparable. 

Chairman BAKER. Do you have knowledge that they are? Or that 

is what you believe as to their professional responsibility? 

Ms. NAZARETH. I believe that they have procedures that establish 

that they should uniformly apply with respect to their reviews. 

Whether or not they actually do that is another question. I would 

hope that they do that, but given that we do not have examination 

authority or the ability to audit that, I cannot represent that that 

is what is happens. 

Chairman BAKER. I appreciate that problem. Thank you very 

much. 

Mr. Kanjorski? 

Mr. KANJORSKI. Ms. Nazareth, we talked about the discussions 

that are ongoing. I suspect that is between the SEC and the rating 

agencies? 

Ms. NAZARETH. Yes. 

Mr. KANJORSKI. How long have they been ongoing? 

Ms. NAZARETH. Well, it has been off and on. There were holidays 

in between and other events, but I think we started talking around 

November. 

Mr. KANJORSKI. Could you give us just your initial reaction of 

how successful those discussions have been to date? I notice the 

one suggestion that they are not able to be regulated because of the 

protection of the First Amendment. Are the major five rating agencies asserting that on a regular basis, seemingly without fear? 

Ms. NAZARETH. It is a complicated process. I have to say that in 

the past when we have negotiated voluntary initiatives with entities, they tended to be entities that we had regulated for other purposes and therefore were used to SEC oversight. The question was 

whether or not in a new area of their business they would agree 

to some sort of voluntary regime. 

This is a little more difficult. I believe that the rating agencies 

are dealing with us in good faith, but it is more difficult given that 

they are not really as used to SEC oversight. There are some legitimate questions on First Amendment issues and concerns about regulators imposing themselves into the editorial process that they are 

10

very sensitive to. So I think it has made the discussions somewhat 

more complicated, to say the least. 

Mr. KANJORSKI. Are you more optimistic than Chairman Donaldson seemed to be in his testimony before the Senate? 

Ms. NAZARETH. I don’t know if I would say more optimistic. I certainly agree with the tenor of his testimony. I am certainly willing 

to continue our discussions, but I think Congress should continue 

its review at the same time and we will see where we come out. 

Mr. KANJORSKI. You heard in my opening statement the fact that 

I am addressing a letter today to the Commission to give us an outline of the additional authorities you think you may need in order 

to carry on an officially sanctioned involuntary regulation of these 

entities. From what I gather from the chairman’s comments, he 

tends to agree that we now need that. Can that be forthcoming in 

a reasonably short period of time? 

Ms. NAZARETH. Yes, we could definitely do that. 

Mr. KANJORSKI. I have a feeling that we have had some consideration of this issue for a number of years now. Can you give me a 

qualitative evaluation of success in that ongoing process? Or is this 

just dragging along at the slowest rate to accomplish no regulatory 

authority? 

Ms. NAZARETH. I think certainly we have had some progress in 

the sense that the Commission now has proposed a rule that is intended to add greater transparency to the process of granting noaction relief regarding NRSROs. That is progress. I think it is 

progress that Congress is partnering with us to look at this issue 

and to determine whether now is the time to have additional authority or whether to rely on private sectors means. But I do think 

that this is the next opportunity to make some progress in this 

area. 

Mr. KANJORSKI. My druthers would be that we do not have to 

regulate, as I am sure Mr. Donaldson and you would join us in 

that. But do you think that they doubt that we have the backbone 

here in the Congress to take such action? 

Ms. NAZARETH. Who would doubt the backbone? 

Mr. KANJORSKI. These rating agencies. 

Ms. NAZARETH. I do not think anyone doubts your intentions. 

Mr. KANJORSKI. Is there any stronger message that we can send 

to them? Would it be introduction of authorizing legislation to give 

regulatory authority to the Commission? Would that help in the 

discussions? 

Ms. NAZARETH. I think they are well aware of Congress’s efforts. 

I think to be frank, I think there is a bit of a dilemma that they 

have as well, because if they start investing the time in a voluntary 

initiative and congressional authority is forthcoming, it may be 

that they have to switch gears and do things somewhat differently. 

So they have a little bit of a dilemma themselves in terms of 

whether they should at this point invest the resources in that effort, or should they wait for Congress to give us authority and then 

just wait for a rulemaking. 

Mr. KANJORSKI. Does that underlie the observation on your part 

that they perhaps are not doing their best in investing time and 

effort in these ongoing discussions? 

11

Ms. NAZARETH. I think it is a factor. I would not say they are 

not doing their best. They are five very different organizations with 

different structures that also have to try to come to some common 

conclusion on what to do. But I certainly think the combination of 

Congress’s review of this issue as well as a number of initiatives 

in Europe has made it difficult for them to assess what exactly is 

going to be the landscape in which they are operating, and should 

they take the lead or should they wait to see what happens. 

Mr. KANJORSKI. Well, if I can again urge you to get that outline 

of the authorities necessary to pursue this as fast as possible to see 

whether or not they can invest some of their time in responding to 

the actual legislation. 

Thank you. 

Chairman BAKER. I thank the gentleman. 

Mr. Hensarling? 

Mr. HENSARLING. Thank you, Mr. Chairman. 

Ms. Nazareth, I think you indicated in your testimony we have 

five recognized NRSROs. I am curious, does the SEC have information on just how many market participants there are out there, 

how many credit rating agencies there are who have not achieved 

the NRSRO status? 

Ms. NAZARETH. The information that we have is that there are 

probably at this point over 100 credit rating agencies. The number 

of participants has actually expanded quite a bit. I think the FSA 

recently discussed the number of participants and it was quite interesting to us. A great number of them have not expressed any interest in applying for this. In other words, their business models 

do not dictate that they have to be in this NRSRO business in 

order to be successful. 

Mr. HENSARLING. Would you say that the number has been increasing in recent years? 

Ms. NAZARETH. I believe it has been increasing, yes. 

Mr. HENSARLING. Can you discuss aspects of market evolution or 

technology that might account for this fact, I guess really over the 

last couple of decades, since the SEC first designated the NRSRO 

regulation, back in 1975? Can you talk about trends that might 

have led to the fact that there are indeed more rating agencies now 

and what has led to that? 

Ms. NAZARETH. I gather that there is obviously a tremendous appetite for investment in debt securities and the number of products 

and the complexity of debt products have really been explosive in 

the last several decades. There is an appetite and a market for 

good in-depth analysis in order to understand these products. So a 

number of market participants are willing to pay for these analyses 

to help them better understand their particular issues. 

Mr. HENSARLING. It sounds like there has been an increase perhaps in the number of these rating agencies who are dealing in 

niche markets. I believe on page six of your testimony you talk 

about that even though a credit rating agency might only rank 

debts, say, in a limited sector of the market or in a geographic 

area, they might be able to achieve the NRSRO status. But it does 

not sound like in reality or in practicality that is actually happening, since we still have only five. Is this correct? 

12

Ms. NAZARETH. This is the first time we have articulated this 

goal of recognizing entities that are in these limited sectors, although we have historically done so. Again, I think it depends on 

whether these market participants choose to apply. We have had 

several instances in the past where we would have been more than 

happy to entertain the requests, but there was no interest on the 

part of those credit rating agencies to apply. 

Mr. HENSARLING. Last year before this subcommittee, there was 

a gentleman from the American Enterprise Institute, Alex Pollock, 

who called the current NRSRO designation a catch-22 because, and 

I am sure you have heard the argument, if you are a non-NRSRO 

you have to become widely accepted to become an NRSRO. But if 

you are not an NRSRO, say that three times quickly, you cannot 

become widely accepted. So how do you address his argument that 

we will continue to have a catch-22 under these new guidelines? If 

so, how will we ever go beyond our five recognized agencies? 

Ms. NAZARETH. Again, I think there are, as we have said earlier, 

there are over 100 of these entities, many of which are very highly 

regarded in their niche markets. Should they choose to apply, we 

would be very pleased to consider their applications. We have in 

the past recognized NRSROs within 5 years of their beginning to 

rate debt securities. 

So it is something that we are very obviously concerned about 

and interested in. We believe that it is important for purposes of 

SEC regulations that the term apply to firms that really are providing a rating that is based on a process with high integrity and 

that is widely recognized in the marketplace. 

That having been said, we do not want this regulation in any 

way to impede competition or the ability for new entrants to enter. 

So hopefully this new definition with its emphasis on the niche 

players as well will assist in that area. 

Mr. HENSARLING. I see I am out of time. 

Thank you. 

Chairman BAKER. Ms. Wasserman Schultz? 

Ms. WASSERMAN SCHULTZ. Mr. Chairman, I do not have any 

questions. Thank you. 

Chairman BAKER. I thank the gentlelady. 

Ms. Kelly? 

Mrs. KELLY. Thank you, Mr. Chairman, for holding this hearing. 

Quite frankly, I appreciate your appearing here, Ms. Nazareth. 

You state in your testimony that Congress has given no authority 

to the SEC to regulate nationally recognized credit rating agencies. 

In my estimation, the ability of the SEC to identify and define 

the NRSROs contains the ability to define NRSROs to exclude from 

the definition any institution that fails to meet the standards the 

SEC expects. Do you agree with that? Could you please explain it? 

Ms. NAZARETH. Yes, we certainly have the ability to define the 

term and to interpret which entities meet that definition. What we 

do not have express authority to do is to have an ongoing oversight 

regime to ensure that those who meet the definition continue to do 

so and that some of the really fundamental principles on which we 

determine to grant the no-action letter continue to exist. 

Mrs. KELLY. Which means that you are seeking authority from 

Congress to rate the raters. Is that correct? 

13

Ms. NAZARETH. No. We are not seeking authority. We have no official position on seeking authority. What is being discussed is 

granting the Commission authority to have an oversight regime for 

those entities who fit the definition and who have applied for recognition. 

Mrs. KELLY. The courts ruled that speech about credit worthiness is protected by the First Amendment. Wouldn’t the explicit 

regulation of the NRSROs violate their First Amendment right to 

speak freely on the financial markets? 

Ms. NAZARETH. There are issues on journalistic privilege and 

First Amendment issues that do factor into this analysis, which is 

why we feel that it is very important for Congress to be involved 

in this determination. If Congress determines that more regulatory 

oversight is necessary in this area, for Congress to expressly grant 

that authority because we feel that to take an aggressive position 

in this area, particularly where there are First Amendment issues 

involved, would not be appropriate. 

Mrs. KELLY. I am not quite sure how the SEC authority, how 

broad that is. Is it limited to how the publicly traded companies 

use the information that they get, whether it is paid or unsolicited 

from credit agencies? Can you define just a little bit more about 

how broad that is? 

Ms. NAZARETH. Yes, the term was originally used for a very limited purpose, which was to describe those entities who rated debt 

securities, whose investment-grade ratings could be relied upon by 

broker-dealers for purposes of some capital benefits under the net 

capital rule. So it basically said if a broker-dealer had in its portfolio bonds that were rated investment grade, those bonds would 

have a lower haircut or a lower capital charge to the firm’s capital 

than would bonds that did not have such a rating. 

So it was really a way for the Commission to determine that to 

give this regulatory or capital relief, but doing so in a way that it 

felt was responsible in that the ratings that were being relied upon 

were generally accepted as reliable and credible ratings. It was 

used for that purpose. 

What happened was the term over time became a useful proxy 

for creditworthy ratings, and was used in other SEC regulations 

and then was used in a number of regulations, both by the states 

and abroad. We feel that given the reliance that is put on this definition that it would be certainly more appropriate to have some 

sort of ongoing review of whether the entities that enjoy this designation continue to meet up to the terms of the definition. 

Mrs. KELLY. Credit rating agencies have been accused of maintaining high ratings on some issuers and arbitrarily lowering others. I am amazed at some of the stories that I have read where 

schools have been bent over backwards by some of these agencies, 

municipalities, businesses. I think the public really does not know 

that schools, municipalities and businesses have to pay the credit 

rating agencies in order to get those credit ratings. 

It seems to me that instead of trying to regulate the NRSROs, 

the market might be best served to encourage as many people to 

go into the credit reporting field as possible in order to provide a 

lot of viewpoints, and then let market forces make whatever correcVerDate 0ct 09 2002 10:23 Aug 31, 2005 Jkt 000000 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 G:\DOCS\23047.TXT FIN1 PsN: MICAH
14

tions they are going to make in that field. I would be interested in 

what your response is to that. 

Ms. NAZARETH. I think, as I said before, there are a number of 

people in this field. There are over 100 credit rating agencies. 

Again, this term was used by the Commission for much more narrow purposes and has taken on a life of its own. There is nothing 

in the use of the term or there is nothing that would in any way 

require investors to rely solely on the ratings of these raters. There 

are a number of other services that they could use. 

Mrs. KELLY. I am sorry. I really did not understand that. You 

said there are a lot of people in the field, but there are only five 

NRSROs. 

Ms. NAZARETH. Right. 

Mrs. KELLY. There are hurdles, if I understand the Chairman’s 

and Mr. Kanjorski’s and Mr. Hensarling’s comments, hurdles that 

these other agencies really have to jump, and there have been precious few. It seems to me congressional pressure has pushed the 

SEC to at least admit two more agencies because there were originally only three. 

I do not see how these others in the field are going to get into 

the business if we have high hurdles and more regulation. 

I am out of time. Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentlelady. 

Ms. Brown-Waite? 

Ms. BROWN-WAITE. Thank you very much, Mr. Chairman. 

I came in probably towards the end of your testimony, but the 

basic question that I have is that in your new proposal, you are apparently limiting it solely to implementation of a definition and you 

do not plan to take any other action with regard to NRSROs without specific statutory authority. 

Have you asked for that statutory authority? You may have covered this in your testimony. 

Ms. NAZARETH. The Commission has not yet taken a position on 

whether it is requesting statutory authority. What the Commission 

has done is make clear that it believes that to do more would require statutory authority. 

Ms. BROWN-WAITE. I think you are repeating what I said. Are 

you requesting statutory authority? 

Ms. NAZARETH. No, we are not at this time officially requesting 

statutory authority. 

Ms. BROWN-WAITE. So if I understand you correctly, then you are 

just going to do the same old-same old and not expand the number 

of them? 

Ms. NAZARETH. That has nothing to do with the statutory authority question. That goes to the definitional question. We would be 

able to, I believe, designate or recognize additional credit rating 

agencies as NRSROs under this definitional rulemaking that we 

have done. Whether or not we have the authority to do more ongoing oversight of those entities once they receive the no-action letter, 

that goes to the issue of authority, ongoing oversight, examinations, recordkeeping requirements, potential registration requirements. 

But the Commission does have the authority to define the term 

‘‘NRSRO’’ and that is what the proposed rulemaking seeks to do. 

15

It also seeks to expand potentially the universe of firms who would 

be able to satisfy that definition by making it clear that one could 

be ‘‘nationally recognized’’ even though that firm is really more recognized for a limited sector of the market or a limited geographical 

area. So there is a recognition that while we feel we need to have 

high standards in the definition, we also do not want the definition 

to preclude additional parties from being able to apply and to obtain the NRSRO no-action letter. 

Ms. BROWN-WAITE. After Enron and WorldCom, I think the question needs to be asked: Who really has oversight over these 

NRSROs? Do the firms require continuous education? Our whole 

economy was thrown on its heels partially as a result of the Enron 

and WorldCom scandals. So what kind of self-governing, maybe is 

my question, do they engage in? 

Ms. NAZARETH. Well, all the credit rating agencies have policies 

and procedures in place that include standards on the educational 

backgrounds of the people they hire and on how frequently they review the firms that they rate and the like. Those procedures are 

supposed to obviously be rigorously internally enforced. 

Frankly, one of the issues that we will have whether or not the 

Commission gets authority here is that there are some things that 

it will be difficult for regulation to address. Regulation is not going 

to make anybody faster or smarter, but we can require that people 

have rigorous procedures that they follow and hopefully that in and 

of itself will improve the process. Certainly having procedures on 

conflicts of interest and disclosure of nonpublic information and the 

like is important to have in any industry. But it certainly will not 

be a guarantee against mistakes in the future in any area. 

Ms. BROWN-WAITE. I do not think you answered my question, 

and maybe you are not the right person to answer this, but who 

really governs the NRSROs? 

Ms. NAZARETH. They are not regulated. 

Ms. BROWN-WAITE. They are not regulated at all? Totally not 

regulated? 

Ms. NAZARETH. As part of the no-action process, they were registered as investment advisers, but really their advisory work is 

minimal at best. So for these purposes, their credit rating processes 

are not regulated. 

Ms. BROWN-WAITE. Thank you. 

Chairman BAKER. I am going to start a second round. Since we 

have a limited number of members, it will not take long. 

Just to follow on to Ms. Brown-Waite’s observations, there is no 

process clinically established in law or in regulation on how you become one of these things. Up to the contemplated rule now pending, you had to be nationally recognized. If you were not national, 

you could not be considered. 

Now we have a three-part test which is sort of nationally recognized. You do not have to be national in organizational scope, with 

offices from California to New York, but you have to be recognized 

nationally for your work in the field of oil futures. You have to 

have the financial stability to be able to operate on a national basis 

and have a proven record of credible, reliable, analytical work. 

Strangely enough, that standard does not now apply to those who 

are NRSROs. We do not know, for example, that all five have the 

16

similar procedure for gauging the financial credit worthiness of all 

those in the oilfield sector. One could be using one methodology; 

one could be using another. But the investment company world requires that that oilfield company which is going to issue public debt 

have at least two ratings from two independent entities. 

When you look at the way the structure of the current process 

works, the profit margins are excessively egregious, and that is 

only because we have the voluntary disclosure by some of their 

rates of return. Some do not even disclose their financials period. 

They are the only entities that have an exception from Reg FD. 

They can get access to material fact that no other person can get 

and make disclosure of subsequent to some civil or criminal action, 

and they can make selective disclosure of information pursuant to 

executive interview. 

Then they say if we are going to have the SEC either by rule or 

by statute come in and perform an audit of the books to find out 

if somebody has cooked their books or if somebody is running off 

to Tahiti with shareholder funds, they say wait a minute, you are 

going to abridge our First Amendment rights. Huh? If you want to 

find out as to the analysts who are performing the work have been 

previously accused of fraudulent activities in the world of accounting, they hold up the First Amendment shield. 

Now, the First Amendment shield only goes to the preparation 

and release of a statement publicly made. By removing their designation as an NRSRO, they can still make all the statements they 

want, they just cannot charge very much for them. Therein is the 

problem. We have a monopoly governmentally granted without a 

clear standard of conduct to maintain professional accreditation. By 

the way, there has never been any entity designated an NRSRO 

that has ever been decommissioned, and I would like in a minute 

to ask what is the process to decommission someone if you find out 

that they have engaged in blatant fraudulent conduct. 

These enterprises are not outside the law. There is no law. This 

is the Wild West, and if you ride through their ranch and you do 

not pay their fee, you get shot. You are required under the Investment Company Act to ride across their ranch. If you do not pay 

their freight, you are in real trouble. Plus, they will show up on 

your ranch unannounced, perform an audit, and then give you a B 

rating when you ought to be an A rating. What is your recourse? 

They have the public operating companies of this country by the 

throat. This has got to be at least subject to disclosure and awareness by the public as to what is going on here because 4 days before Enron, the three NRSROs that were designated at that time 

in our country’s history all of them listed Enron as investmentgrade investments. 

Now, you remember what this committee did to the analysts and 

the investment bankers for missing it by a year? What are we 

going to do to these guys for missing it by 4 days? And yet we still 

have a commission that has been reviewing this matter for over a 

decade. This committee has been looking at it for almost that long. 

I do not make this to be interpreted as any kind of threat at all. 

I am saying this out of frustration. We need to help you. We need 

to give you the authority to act. We need to make sure that these 

17

people are responding to the market need in professional criteria. 

And we will have legislation. 

Now, I cannot speak to the content of that bill. I do not know 

your ability, given the lack of commission direction at this point to 

be able to comment, and I do not want to get you in that adverse 

position. But should you and those of your office choose to work 

with us in the formulation of a bill that is responsive, I have no 

confidence in a voluntary agreement. I have had bad experiences 

with those. 

So I think going forward, we are just going to have to give the 

agency the ability to regulate and subsequently to that or concurrent with that, figure out a way to get past this NRSRO designation business and let people who want to rate, rate. We do not do 

that in the securities and the equities world. We have all sorts of 

analysts giving all kinds of ratings all day long. If you want a rating, I am sure you can find the one you want because they are all 

over the map. The point is the market works without having a governmental designation of who should become a rating agency. 

Back to my question, since I rambled on for my entire time, has 

there ever been an NRSRO once designated ever decommissioned? 

And is there a process for doing so? 

Ms. NAZARETH. There has not been one that has been decommissioned. Again, I am not sure what I would conclude from that because certainly one of the issues is the ability to do a rigorous ongoing oversight, which more authority would give us. Since there 

has not been as rigorous ongoing review——

Chairman BAKER. Let me help you. What you are saying is the 

regulator does not have the tools to know whether they are doing 

a good job or a bad job. Therefore, how could you decommission 

them without the facts? 

Ms. NAZARETH. But we certainly do have the authority to remove 

the no-action letter. As with any market participant, we have enforcement authority to go after any sort of illegal act under the securities laws. 

Chairman BAKER. So you would tell me that over the course of 

the 1980s and the 1990s, when investment bankers, analysts, securities markets, mutual funds, everybody you can name in the financial services sector got it wrong and there were people held criminally accountable in most cases, that the monopoly of the credit 

rating agencies was above the fray and did everything right. 

Ms. NAZARETH. It was not subject to the same regulatory oversight as those entities. 

Chairman BAKER. Thank you very much. 

Mr. Kanjorski? 

Mr. KANJORSKI. Mr. Chairman, what I love about you is you 

make me look like a flaming conservative. 

[Laughter.] 

I think we are pretty much in agreement that the committee 

wants to do something that will arm the SEC with the authority 

to accomplish its end. I do not know I am as far as the Chairman 

on these conclusions, but certainly we are both thinking along 

those lines. 

Chairman BAKER. I will give you a little time. You will get there. 

[Laughter.] 

18

Mr. KANJORSKI. I will come there. 

The one question I did want you, Ms. Nazareth, to address, in 

the 1990s the Commission came very close to issuing rules and regulations regarding the control of the credit rating agencies, and 

then they did not act. At that time, therefore they must have made 

the conclusion that they had the legal authority to do that. Has 

anybody revisited why that has changed? I know at the time I do 

not think they could get a majority of the Commission to adopt the 

rule, but somebody must have structured the legal authority there 

in existing law. 

Ms. NAZARETH. Even in the 1990s, the proposal from 1997 was 

quite similar to the proposal that the Commission put out for comment last month. It was marginally more aggressive on the authority side, but not terribly so. I think that in light of various challenges to the Commission’s authority and in light particularly of 

the First Amendment issues that have been raised, we think it 

would be prudent to wait for authority to do anything beyond the 

definitional term. 

Mr. KANJORSKI. The comments that the Chairman made regarding almost extortion, have you heard complaints of this or factual 

information that would support that in some instances these entities have acted in that regard? 

Ms. NAZARETH. I think historically there were complaints about 

unsolicited ratings. My understanding was that several years ago 

the Department of Justice actually looked at it and took no action. 

My understanding is also that since that time, the rating agencies 

became I think more sensitive to the issue. I have not heard quite 

the number of complaints in recent years that we did in the past. 

I think that there has been more of a sensitivity to indicating on 

the rating itself that it was unsolicited. But I think unsolicited ratings do still exist, but I am not sure at quite the same magnitude 

that they did in the past. 

Mr. KANJORSKI. Okay. The only other question that I have is, 

you talked about a remedy as releasing the use letter? Or withdrawing the use letter? 

Ms. NAZARETH. Withdrawing the letter, yes. 

Mr. KANJORSKI. How could you do that if you have no criteria on 

which it is issued? 

Ms. NAZARETH. The criteria was always articulated in the area, 

what we had looked at in order to issue the letter. So certainly if 

we became aware of the fact that the basis on which the letter was 

issued no longer applied, we could withdraw the letter. The question is how much comes to our attention and whether there is an 

ongoing process to examine for that. 

Mr. KANJORSKI. There is no question, though, that we should get 

involved in this area. 

Ms. NAZARETH. I think Chairman Donaldson was quoted that we 

welcome your involvement. 

Mr. KANJORSKI. Thank you very much, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Ms. Kelly? 

Mrs. KELLY. Thank you, Mr. Chairman. 

Ms. Nazareth, I received a letter that indicated, it was actually 

from S&P. It indicates that S&P ratings was designated as an 

19

NRSRO in 1976, although it did not affirmatively seek that status. 

If they could be declared an NRSRO without applying and without 

affirmatively seeking that status, can’t the SEC just declare a company an NRSRO without asking the designee? 

Ms. NAZARETH. At that time, the request was made by members 

of the brokerage industry who wanted to be able to rely on S&P 

ratings for purposes of the capital rule. So there was a request. It 

was not made directly by S&P. 

Mrs. KELLY. If other agencies now, credit rating agencies, had 

the same event happen, couldn’t the SEC declare a company an 

NRSRO without the designee asking? 

Ms. NAZARETH. It is a little difficult because it still requires the 

cooperation of the entity because there are a number of things, as 

the definition of the proposed rule would imply, that we would 

have to look at. There is a lot of proprietary information that we 

would only be able to get if we had the cooperation of the entity. 

But certainly, more recently I think the requests have come directly from the credit rating agencies themselves, but originally the 

procedure was that the securities industry would ask whether they 

could rely on the ratings of a particular credit rating agency for 

purposes of the rules. 

Mrs. KELLY. What if a consumer asked for a credit agency to be 

rated? What you implied by your answer to me, if I understand you 

correctly, is yes, the SEC could if the person who someone has 

asked to be rated an NRSRO, if they cooperated with you, you 

could go ahead and rate them as an NRSRO if someone came forward and said, I would like to see this agency put in. Can the consumer do that? 

Ms. NAZARETH. We have two different ways. Either the credit 

rating agency that wishes to be considered an NRSRO asks directly, or an entity that has to make use of the term for our rules 

has to ask for it. So it is not just a consumer asking for it. A consumer I do not believe would have standing here. It would either 

be in this case S&P or someone who has to use the term for purposes of the rules. 

Mrs. KELLY. I am just thinking of a group of schools or colleges. 

If they banded together and said, look, we would like you to declare 

this credit rating agency, which is currently not an NRSRO, to be 

an NRSRO, and that credit rating agency worked with you, you 

could in fact declare them to be an NRSRO. Is that correct? 

Ms. NAZARETH. Yes. Any credit rating agency could apply. As 

long as they cooperate, we could treat it as if they had applied 

themselves. 

Mrs. KELLY. I have another question about the rule that has not 

yet been published. Basically, from what I understand, there are a 

bunch of different prongs. One of them says that an NRSRO must 

be ‘‘generally accepted’’ as an issuer of credible and reliable ratings. 

Another one says an NRSRO must use systematic procedures to ensure ratings quality, manage conflicts, prevent misuse, et cetera, et 

cetera. 

My question is that both of those terms, ‘‘generally accepted,’’ 

‘‘systematic procedures,’’ are very difficult to define. Without very 

precise wording on the definitions, I do not see the transparency 

needed here for people to understand what your rule is going to 

20

say. Are there going to be very specific definitions beyond just 

these two terms? 

Ms. NAZARETH. Those are the definitions that the release, which 

you have not had the opportunity to read, will set forth on how one 

would go about satisfying the various prongs. It would give examples of what a credit rating agency could show the Commission to 

evidence that it meets that criteria. It asks whether, because it is 

a proposal, it asks whether other indicia should be considered as 

well. So at this point, obviously it is a proposal. It is not the final 

rule, but it does give a lot more meat to the definition and asks 

for comment on additional criteria. 

Mrs. KELLY. I think the most important thing here is that we 

make sure that anything that happens with regard to oversight, 

and it is clear to me, I agree with our chairman and Mr. Kanjorski, 

I think there is a need for us to really examine this and get it 

right. But we definitely need transparency, and I am very concerned about reducing regulatory barriers because to do that opens 

up the market which I think can only be good. I am a true believer 

in free markets. 

Thank you very much for testifying today. 

Ms. NAZARETH. Thank you. 

Chairman BAKER. Thank you, Ms. Kelly. 

Ms. Wasserman Schultz? 

Ms. WASSERMAN SCHULTZ. Thank you, Mr. Chairman. 

Ms. Nazareth, I just wanted to ask you to clear up some confusion because a couple of minutes ago in response to a question you 

said that you would welcome, as a result of Chairman Donaldson’s 

indication, our involvement, but you are in the process of preparing 

a voluntary framework. 

So I guess I want to have you clarify the seemingly conflicting 

statements. Do you think a voluntary framework is enough and 

how would it work? Or do you think we should get involved as a 

congress and statutorily require regulation? 

Ms. NAZARETH. We have not arrived at a final voluntary framework, so it is not possible for us to say whether that would be sufficient. I do think that this committee has expressed enough concern 

about the issue that I think it would be inappropriate to say that 

the committee should not on its own consider the issue, particularly since it is a very nuanced one. It does go beyond simply regulating an entity. It does raise First Amendment and other issues 

that have to be balanced in the process. That is why I think it is 

an appropriate issue for Congress to address. 

Ms. WASSERMAN SCHULTZ. Do you have an opinion on whether 

or not you think a voluntary framework is enough? It is not that 

it is not appropriate for you to comment. You are in the process of 

developing a voluntary framework. 

Ms. NAZARETH. I cannot speak for the Commission on the issue, 

and frankly I do not think the Commission has really been able to 

fully vet the issue either. But I guess what I am concerned about 

is that, or at least to be cautious about, is that Congress rightfully 

has high expectations of what they expect to happen in this area, 

and if you are looking, frankly, for a regime that is most similar 

to other regulatory regimes we have, it would be very difficult for 

a voluntary initiative to meet all of those criteria. 

21

For instance, to require people to maintain books and records 

similar to what a broker-dealer would require or to permit our examiners to go in and request emails, all the things that we do with 

broker-dealers I think would be unlikely to be achieved through a 

voluntary initiative. 

On the other hand, I am sure there are some real benefits that 

we could achieve through a voluntary initiative. So it partly depends on what people’s expectations are, whether they want to do 

it in a two-step process to see how a voluntary initiative goes, or 

whether they think now is the time to go consider a more fullblown regulatory program. 

Ms. WASSERMAN SCHULTZ. Okay, thank you. 

I yield back the balance of my time. 

Chairman BAKER. I thank the gentlelady. 

I certainly want to express my appreciation to Ms. Nazareth for 

appearing here today. As is evidenced, the various members have 

different perspectives on the issue, but suffice it to say there is concern about moving forward. We certainly wish to be cooperative 

with and of assistance to the SEC in its deliberations. 

We look forward to working with you in the coming days. 

Ms. NAZARETH. Thank you very much. 

Chairman BAKER. Our meeting stands adjourned. Thank you. 

[Whereupon, at 3:19 p.m., the subcommittee was adjourned.] 

(23)

A P P E N D I X

April 12, 2005

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