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H.R. 2990—THE CREDIT RATING

AGENCY DUOPOLY RELIEF ACT

HEARING

BEFORE THE

SUBCOMMITTEE ON 

CAPITAL MARKETS, INSURANCE AND 

GOVERNMENT SPONSORED ENTERPRISES

OF THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

NOVEMBER 29, 2005

Printed for the use of the Committee on Financial Services

Serial No. 109–66

(

(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: 

November 29, 2005 ........................................................................................... 1

Appendix: 

November 29, 2005 ........................................................................................... 29

WITNESSES 

TUESDAY, NOVEMBER 29, 2005

Egan, Sean, Managing Director, Egan-Jones Ratings Co. ................................... 15

Macey, Jonathan R., Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law, Yale Law School ..................................................... 13

Reynolds, Glenn L., Chief Executive Officer, CreditSights, Inc. ......................... 6

Roberts, Richard Y., Partner, Thelen Reid & Priest LLP, on behalf of Rapid 

Ratings Pty Ltd. ................................................................................................... 11

Stevens, Paul Schott, President, Investment Company Institute ....................... 9

APPENDIX 

Prepared statements: 

Egan, Sean ........................................................................................................ 30

Macey, Jonathan R. .......................................................................................... 37

Reynolds, Glenn L. ........................................................................................... 42

Roberts, Richard Y. .......................................................................................... 51

Stevens, Paul Schott ........................................................................................ 68 

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Financial Executives International: 

Letter to Securities and Exchange Commission, June 9, 2005 ..................... 82

Letter to Hon. Richard H. Baker, November 29, 2005 .................................. 89

(1)

H.R. 2990—THE CREDIT RATING 

AGENCY DUOPOLY RELIEF ACT 

Tuesday, November 29, 2005

U.S. HOUSE OF REPRESENTATIVES, 

COMMITTEE ON FINANCIAL SERVICES

WASHINGTON, D.C. 

The committee met, pursuant to call, at 10:05 a.m., James A. 

Byrne Courthouse, Ceremonial Courtroom, Philadelphia, Pennsylvania, Hon. Michael G. Oxley (chairman of the committee) presiding. 

Members present: Representatives Oxley, Baker, and Fitzpatrick. 

ChairmanOXLEY. The committee will come to order. 

Good morning. We are here today in the beautiful City of Philadelphia, the City of Brotherly Love, to focus on H.R. 2990, the 

Credit Rating Agency Duopoly Relief Act, introduced by Bucks 

County’s own Congressman, Mike Fitzpatrick. I would like to take 

a few minutes to assess the committee’s oversight of the rating 

agency industry. In response to the largest corporate scandals in 

U.S. history, Congress passed the Sarbanes-Oxley Act, strengthening the role of gatekeepers, such as auditors and boards of directors, audit committees, and equity analysts. 

Another gatekeeper, the credit rating agency, became a focus of 

Congressional interest because the dominant rating agencies had 

rated WorldCom and Enron investment grade just prior to their 

bankruptcy filings. Wanting to understand an industry with such 

a significant impact on the markets, Congress directed the SEC to 

study the credit rating industry. Since the release of the SEC’s report in January of 2003, the Capital Markets Subcommittee, under 

the leadership of Chairman Baker and Ranking Member Kanjorski, 

has held a series of hearings to explore the areas highlighted in the 

SEC’s report about the industry, the barriers to entry, the conflicts 

of interest, and the lack of transparency regarding rating methodologies. 

The SEC, a number of rating agencies, public company trade associations, and academics have all testified before the subcommittee about the industry. Congressman Fitzpatrick’s legislation, the Credit Rating Agency Duopoly Relief Act, reflects many of 

the reform ideas suggested by these witnesses. Witnesses repeated 

three problems in the credit rating agency industry: the lack of 

competition, the lack of transparency, and the lack of accountability. 

Congressman Fitzpatrick’s legislation works to correct all those 

problems. First, H.R. 2990 fosters competition by simply requiring 

all eligible rating agencies to register with the SEC. The registraVerDate 0ct 09 2002 10:49 Jun 01, 2006 Jkt 000000 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 G:\DOCS\109.66 RODNEY
2

tion of credit rating agencies would resemble the registration of 

broker-dealers and investment advisors under the Federal securities laws. Registration would replace the opaque recognition process the SEC staff now uses to select rating agencies. The designation of only a select number of agencies has led to troubling concentration in the industry, with two firms controlling a vast majority of market share. This is far from an efficient market with robust competition. 

The bill takes a further step at encouraging competition by prohibiting anticompetitive practices, such as notching, tying, and unsolicited rating. Smaller rating agencies and public companies have 

repeatedly alleged that the larger firms engage in such practices. 

To improve transparency, H.R. 2990 requires the disclosure of procedures and methodologies used in determining ratings, performance statistics, and conflicts of interest. These requirements would 

go far in shedding light on the operation of these powerful players 

in the financial markets. In addition, the legislation permits the 

SEC to adopt further reporting and recordkeeping requirements in 

the interest of investor protection. And finally, H.R. 2990 enables 

the Commission to oversee the rating agencies through inspection, 

examinations, and enforcement actions. 

We do hope to pursue this reform in the new year. We are holding this second hearing on the bill to ascertain from our distinguished panel of witnesses their views on and suggested enhancements to Congressman Fitzpatrick’s legislation. I look forward to 

hearing their testimony. I now yield to the gentleman from Louisiana, Mr. Baker, the chairman of the subcommittee. 

Mr. BAKER. Thank you, Mr. Chairman. I want to express my appreciation to you for conducting this field hearing and make the observation that when we return to Washington, we really ought to 

examine the structure of our own committee room. I feel a bit 

smarter sitting this high up. It certainly is helpful to be up here, 

I think. 

I also want to express appreciation to Mr. Fitzpatrick for the introduction of H.R. 2990. This is a really big issue. As you appropriately pointed out, the rating agencies are essentially the gatekeepers to the capital markets for access by businesses of all sizes 

to engage in corporate growth and job creation, product development, and all of the things that we see in free enterprise as appropriate and good for our national economy. 

A system such as this should be subject to extraordinary scrutiny 

and held to the highest standards of marketplace accountability. At 

the current time, I don’t believe that can actually be claimed. We 

have a system which has worked, but markets have changed dramatically. The provision of credit flows differently than any time 

before in our country’s history. Technology continues to press the 

change, and as a consequence, it is time for us to look at the gatekeeper’s role in asserting whether or not there could be modifications made that would benefit all players. It is my view that 2990 

brings about an important discussion that we should have engaged 

in some time ago, but certainly have an obligation to carefully consider the provisions of the bill, as Mr. Fitzpatrick has proposed 

them. 

3

The current and existing leaders in the provision of ratings 

would no doubt, after implementation of 2990, remain the predominant providers of ratings in the system, were the system changes 

brought about as proposed under the Fitzpatrick plan. But certainly, it would give at least regional specialists the opportunity to 

stay in the oil patch, to do skilled work, and be helpful in bringing 

about a higher degree of accountability by the major players, not 

only as to the way in which the work is engaged, but the product 

quality itself. It shouldn’t need to be said again, but probably needs 

to be said again, that very few sectors of the market performance 

met our expectations during the Enron-WorldCom days. And to 

look at the performance of these enterprises in that light, there certainly is hope for improvement in future performance as we make 

needed changes to the regulatory system. 

It is my hope, Mr. Chairman, that the committee will return to 

Washington sooner rather than later to formally consider the provisions of 2990, move forward on the bill as best we can, and certainly in the course of the hearing today, as witnesses give us their 

perspectives on how the bill may be enhanced, improved, or otherwise modified, to certainly welcome those comments. It is important that if we are going to have a market-based ratings system 

that we communicate with the professional leadership of the market in helping structure how that plan should best be implemented. 

To that end, I am appreciative for your time in being here in the 

great City of Philadelphia this morning, Mr. Chairman. Thank you. 

ChairmanOXLEY. I thank you and now recognize the gentleman 

from Pennsylvania, who is the author of the legislation, Mr. 

Fitzpatrick. 

Mr.FITZPATRICK. Thank you, Mr. Chairman. 

First, let me welcome Chairman Oxley and Chairman Baker to 

the City of Philadelphia, sometimes referred to as the Cradle of 

Liberty, where 230 years ago, not too far from here, some patriots 

decided to challenge the status quo and make a better life for 

themselves and for their children. We are certainly very proud of 

our history in this area, and I am very proud indeed to represent 

this part of Pennsylvania in the United States Congress. And I also 

appreciate, Mr. Chairman, you calling this important field hearing 

today on improving the credit rating industry and allowing me the 

opportunity to speak on behalf of legislation that I introduced, the 

Credit Rating Agency Duopoly Relief Act, H.R. 2990. 

Credit ratings agencies have been issuing credit ratings on the 

likelihood of an issuer’s default on debt payment since the early 

20th century. Today, credit rating agencies rate not only companies, countries, and bonds, but also assets and securities, 

collateralized debt obligations, commercial paper, private placements, certificates of deposit, preferred stocks, medium term notes, 

and shelf registrations. Despite being often underestimated and 

overlooked, their power is indeed immense. Credit rating agencies 

have a great impact on the bottom line of companies, municipalities, and school districts. The better the credit rating, the lower the 

interest rate that the borrower must pay. 

This expansive influence finally came into question on account of 

the recent corporate scandals and the fact that two of the largest 

nationally recognized statistical rating organizations, NRSROs, 

4

Standard & Poor’s and Moody’s, rated Enron and WorldCom at investment grade just prior to their bankruptcy filings. Essentially, 

they told the market that Enron and WorldCom were safe investments, even though their problems were very apparent to the marketplace. As a result, reforming the rating agency industry has 

been the subject of much debate in the House Financial Services 

Committee. 

Before being elected to Congress last year, for 10 years, I served 

as a county commissioner in the county just north of here, Bucks 

County, and many of my constituents held stock in Enron and 

WorldCom, and they were greatly impacted by their bankruptcies, 

just as countless others were across the Nation. S&P and Moody’s’ 

monitoring and reviewing of Enron and WorldCom, in my view, fell 

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

Today there are over 130 credit rating agencies in the market. 

However, only five are designated as an NRSRO by the U.S. Securities and Exchange Commission. The SEC coined the term NRSRO 

without defining it in its 1975 rule on net capital requirements 

when an obligated broker-dealer is to hold more capital for those 

bonds rated junk by an NRSRO. Since then, other regulators and 

the private investment community have taken up the term also, 

though, without defining it. Over the past decade, the SEC has 

issued various releases, reports, and proposals relating to the 

NRSRO designation process and credit agency reform generally. In 

1994, the SEC issued a concept release stating that the most important factor is that the rating agency be nationally recognized, 

that is, considered by the financial markets to be an issuer of credible and reliable ratings. In 1997, the SEC issued a proposed rule 

to codify the requirements for designation outlined in the 1994 release, but the SEC failed to implement the proposal. A possible reason is that the Department of Justice objected to the proposal’s requirement that NRSROs be nationally recognized, that that would 

have been anticompetitive, prohibiting the entry of new market 

participants. 

The SEC’s national recognition system is the root of the problem. 

The NRSRO process is practically an insurmountable artificial barrier to entry. Credit ratings matter only if they are issued by an 

NRSRO; thus, since debt issuers typically seek ratings from 

NRSROs to comply with a regulation or a contract, a rating agency’s lack of designation significantly hinders its ability to garner 

the national recognition required to obtain status. This difficulty in 

obtaining the NRSRO label, due to the nationally recognized requirement and the lack of clarity in the designation process, has 

created a chicken and the egg situation for non-NRSRO credit rating agencies trying to enter the credit rating agency, further fostering a duopoly in the credit rating industry. 

The credit ratings industry is dominated by S&P and Moody’s. 

Together, they have over 80 percent of the market share. Under 

the leadership of Chairman Oxley and Subcommittee Chairman 

Baker, the House Financial Services Committee has received testimony that the lack of competition in the rating industry has lowered the quality of ratings. They have inflated prices. They have 

5

stifled innovation and allowed conflicts of interest and anticompetitive practices to go unchecked. 

I introduced the Credit Rating Agency Duopoly Relief Act to inject greater competition, transparency, and accountability in the 

credit rating agency industry through market-based reform. It enhances investor protection by replacing the SEC’s opaque designation scheme with a more thorough, transparent registration process 

that protects investors. Instead of allowing public companies and 

investors to decide whose ratings to use, the SEC decides for them 

under the current regulatory regime. Ironically, the same regulatory agency that freely allows individual investors, regardless of 

their sophistication, to choose a mutual fund, steps in and refuses 

rating consumers the same freedom of choice. Stranger still is the 

fact that most of the consumers of ratings data are institutional investors, sophisticated actors in the investment community. 

Given the current regime, it comes as no surprise that more 

often than not, the SEC decides to force consumers to use the two 

largest agencies in the market, S&P and Moody’s. My legislation 

would eliminate the SEC staff’s anticompetitive NRSRO process. 

H.R. 2990 would ensure a level playing field for all rating agencies. 

All eligible credit rating agencies would be registered with the SEC 

under the Securities Exchange Act of 1934. Any credit rating agency meeting the definition of a statistical rating organization must 

register with the SEC. To become eligible for and comply with registration as a nationally registered statistical rating organization, 

companies must be engaged in the business of issuing credit ratings for at least 3 consecutive years prior to filing an application 

for registration. In addition, this new definition does not discriminate against certain business models, as the SEC currently does in 

its current definition process, but instead accepts firms with a 

purely quantitative model and investor fee-based model. 

As an additional protection for investors, the Act would also prohibit anticompetitive industry practices and mandates reporting 

and recordkeeping requirements for registered firms, similar to 

those for mutual funds, investment advisors, and brokers. A nationally registered statistical rating organization will be required to 

disclose in its registration application not only its long and short 

term record at rating securities and public companies through performance statistics, but also the methodologies it uses in deriving 

its ratings and the conflicts its business model raises and the manner in which it manages those conflicts. The Credit Rating Agency 

Duopoly Relief Act directs the SEC to develop other reporting requirements as it deems appropriate in the interests of investor protection. Moreover, registered rating agencies will be held accountable under the securities laws. The SEC will be able to inspect, examine, and bring enforcement actions against rating agencies 

under the 1934 Act. My legislation incorporates most of the SEC 

staff’s proposed outline of the regulatory framework. 

A minority of commentators have claimed that any registration 

in this industry amounts to a violation of First Amendment privileges. H.R. 2990 does not infringe upon those privileges. The legislation neither bans nor restricts First Amendment rights in any 

manner whatsoever. The Government has an undeniable interest 

6

in registering rating agencies, given the credit rating industry’s 

substantial effects and impact on the market. 

My legislation regulates the credit ratings industry through disclosure, which is the least restrictive means of regulation. It is important to note that currently, all five SEC approved agencies already registered voluntarily under the Investment Advisors Act of 

1940. By encouraging competition in the industry, prices and anticompetitive practices will be reduced, credit ratings quality will improve, and firms will be required to innovate. H.R. 2990 presents 

a commonsense, market-based approach to reform, the basic problems of the credit ratings industry, while protecting our robust 

marketplace. 

Chairman Oxley and Subcommittee Chairman Baker, thank you 

for your continued leadership in the credit rating industry, and I 

yield back the balance of my time. 

ChairmanOXLEY. I thank the gentleman and want to also congratulate him for his excellent work on this important subject. The 

committee, as all of us have indicated, since the fall of Enron, 

WorldCom, has really concentrated on what I guess we would consider the gatekeepers over time, and this is one of the areas that 

we felt really needed some attention, in terms of more transparency, more competitiveness, and the like, and the committee 

will proceed, when we return in January, with a markup on your 

legislation. 

Let us now turn to our distinguished panel of witnesses. We 

thank all of you for coming here today to Philadelphia to participate: Mr. Glenn Reynolds, chief executive officer of CreditSights, 

Inc; Mr. Paul Schott Stevens, president of the Investment Company 

Institute; Mr. Richard Y. Roberts, partner of Thelen Reid & Priest 

LLP, on behalf of Rapid Ratings Pty Ltd.; Mr. Jonathan R. Macey, 

Sam Harris Professor of Corporate Law, Corporate Finance, and 

Securities Law, with the Yale Law School; and Mr. Sean Egan, 

managing director of Egan-Jones Ratings Company. 

Mr. Reynolds, we will begin with you. 

STATEMENT OF GLENN REYNOLDS, CHIEF EXECUTIVE 

OFFICER, CREDITSIGHTS, INC. 

Mr.REYNOLDS. Thank you. It is my pleasure to be here this 

morning. 

My name is Glenn Reynolds. I am the CEO of CreditSights. We 

are an independent research firm offering a range of research and 

data products and with a heavy focus on credit research. Our primary business is not credit ratings, however, but we do compete 

with some of the rating agencies in some areas. We probably chose 

a different business model than credit ratings, since entering the 

ratings business was essentially impossible under the current regulatory framework. Based on our current business model, we are a 

registered investment advisor regulated by the SEC in the U.S. 

and by the FSA in the UK. 

We have had the opportunity to testify before on the rating agency topic in front of the Senate in March 2002, and the SEC in November 2002, and it has been interesting to watch the process 

evolve. A lot of man hours have been directed at this issue. A lot 

of hearings have been conducted, a lot of testimony filed. The level 

7

of due diligence has been impressive. It is clear that many parties 

have a strong interest in seeing some progress made and have a 

lot at stake in the issue. It is equally clear that some parties have 

a big stake in seeing no action. 

With 4 years since the Enron fiasco and various other market 

implosions now behind us, it is also clear that there has been dramatic change in the securities, banking, and accounting industries 

as we all moved ahead and learned from past experiences. It is safe 

to say that this has not been with the credit agencies. The banking 

and brokerage industry had paid out billions of dollars, totally 

overhauled their approaches to research, addressed conflicts of interest, and altered compensation strategies to deal with some of the 

well-documented issues. The accounting profession has also seen 

sweeping changes in the industry. Business lines have been reorganized. Entire firms have disappeared. The ruling accounting bodies 

have made sweeping changes in disclosure and accounting requirements. In the broader market, corporate management teams are 

now under more stringent guidelines to take responsibility for their 

financial statements and internal controls. 

Remarkably, the one major segment of the capital markets that 

remains on structural cruise control through all of this change is 

the credit rating agencies, or more narrowly, the NRSROs. The 

NRSROs have somehow been able to slow the pace of change, frustrate the timely lowering of artificial barriers to entry, and continue to expand into non-ratings business lines at breakneck pace 

from their protected enclave as an NRSRO. They remain largely insulated from competition by an outdated and anachronistic regulatory framework that the overwhelming majority of reasonable 

people, disinterested or otherwise, see as overdue for an overhaul 

to allow more competition. The agencies have mounted the usual 

defenses, but some facts of life have to be clear. The rating agencies are, in fact, a major force in the capital markets, and they toe 

the line between being an information provider and a de facto part 

of the underwriting process. The regulations have woven the rating 

agencies in the fabric of the securities markets, and the agencies 

have taken every opportunity to tighten the stitching. They hold 

sway over many capital market segments, and most of the major 

trade groups and individual companies are not going to mess with 

them publicly. 

Every next move influences mark-to-market adjustments, reserve 

requirements, asset allocation decisions, forced sale of assets, and 

access to the capital markets generally. They are unique in that position and being essentially devoid of meaningful regulation. They 

have a sweet regulatory deal, and that brings us to H.R. 2990. H.R. 

2990 will immediately address the issue of barriers to entry and 

start the process of injecting some competition into the ratings sector. As the debate continues, it may also shine some light on the 

array of non-ratings businesses that the rating agencies are entering, all the while as they are structurally protected in their main 

credit rating business. As it stands today, an unlevel playing field 

has undermined economic efficiency, kept prices artificially high, 

limited innovation, tapped the brakes on quality, and limited diversity of opinion in the marketplace. Competition does not cure all 

ills, but historically, has sure proven to be a good start. H.R. 2990 

8

gives it that fresh start. There is no doubt that, if passed, we will 

see more competition. 

We can state clearly from our own experience at CreditSights 

that both strategic operators in the financial media space and 

sources of private equity capital see investment opportunities in 

the credit ratings, financial information, and financial data space. 

H.R. 2990 will open up the opportunities, and change will come 

fast. H.R. 2990 is pro-competition, and it is also rational. It will 

lower the artificial barriers to entry and allow market entrants to 

tackle the natural commercial barriers to entry which are demanding enough. The longer the artificial barriers remain up, the higher 

the natural barriers will be stacked by Moody’s and S&P. The ratings industry is, if anything, not a natural duopoly or even a natural oligopoly. In fact, it should be naturally competitive, just like 

the brokerage industry, the banking industry, the asset management industry, and the media industry. Those industries only get 

more competitive. The ratings industry is in stark contrast. With 

Moody’s and McGraw-Hill posting remarkable financial performances, exception profit margins, especially in their financial businesses at McGraw-Hill, and generally dwarfing the stock returns of 

the overall market in the broader peer group of financial companies, it is worth asking why we have not seen major market entrants. Economics 101 tells us something is wrong. That is where 

the artificial barrier part comes in. It is intuitive and obvious that 

market competition is being held back artificially. Scrapping the 

NRSRO designation entirely is preferable to the status quo, but 

some regulation still is prudent, and the disasters of 2001 and 2002 

are there to remind us of that. We realize that the NRSROs are 

mounting a furious defense against even light-handed regulation 

after years of being essentially protected by regulation and generating massive financial benefits from the regulation that kept out 

competitors. 

We would refer you to our formal testimony on some of those 

issues, but a few things are clear. The rating agencies win by 

delay. H.R. 2990 speeds up the process and does so with a measured series of steps. It could use some definitional tweaking, but 

has all the right parts to get a little resolution to the dilemma. The 

market holds more opportunities today than ever in the credit markets for rapid growth, and competition will flourish. Moody’s and 

S&P would like to keep the status quo to capture a bigger slice of 

that growth. Large firms and small firms are waiting in the wings. 

The interests of the duopoly will be for more delay or to water 

down the bill. They will propose to make it voluntary or promise 

a fight. They never offered to make entry voluntary over all these 

years as they frustrated competition. The policy decision here either calls for a major force in the capital markets to be free of all 

regulation or not. Moody’s and S&P will try to make this about the 

First Amendment. The agencies, on the one hand, would have you 

believe their views are like a good or bad movie review in Variety. 

We cannot even believe they can seriously and truly believe this is 

about journalism. 

Philadelphia is a great place for these hearings, to drive home 

the points that this is not about the Constitution. Then again, 

Philly is the right place, since this is all about the Benjamins. It 

9

is about profit, and it is about who gets it. It is about choice and 

not having it. In some ways, it is that simple. 

Thank you to the committee for the opportunity to weigh in on 

these issues. 

[The prepared statement of Glenn L. Reynolds can be found on 

page 42 in the appendix.] 

ChairmanOXLEY. Thank you, Mr. Reynolds. Mr. Stevens. 

STATEMENT OF PAUL SCHOTT STEVENS, PRESIDENT, 

INVESTMENT COMPANY INSTITUTE 

Mr.STEVENS. Mr. Chairman, thank you, and I am delighted to be 

able to join the committee here in Philadelphia this morning. 

As you know, I head the national association of U.S. Investments 

Companies, and our members include both open-end companies, or 

mutual funds, closed-end funds, exchange-traded funds, and sponsors of unit investment trusts, and the credit rating agencies are 

important to each and every one of these classes of our members. 

Our mutual fund members have assets of $8.5 trillion, representing 

more than 95 percent of all U.S. mutual fund assets. They serve 

about 87 million shareholders and more than 51 million households. 

The Institute commends the Financial Services Committee for 

holding this hearing on H.R. 2990, the Credit Rating Agency Duopoly Relief Act of 2005, which is intended to improve the quality of 

credit ratings by fostering competition, transparency, and accountability in the credit rating industry, and to address concerns regarding the current NRSRO designation process. This is my second 

opportunity as president of the ICI to testify before the committee 

which you have so ably led, Chairman Oxley. Under your leadership, and that of Ranking Member Frank, and Capital Markets 

Subcommittee Chairman Baker, and Ranking Member Kanjorski, 

the committee has been active in critically important issues affecting all aspects of our capital markets. This legislation is one more 

example, and I would like to recognize Congressman Fitzpatrick for 

his leadership in advancing this important bill. 

Credit rating agencies play a significant role in the U.S. securities markets generally, and other of the witnesses will talk about 

that. I would like to address their importance vis-a-vis mutual 

funds in particular. Mutual funds employ credit ratings in a variety of ways: to help make investment decisions, to define investment strategies, to communicate with their shareholders about 

credit risk, and to inform the process for valuing securities. 

The most significant influence of credit ratings on the fund industry is on the $2 trillion invested in money market mutual 

funds. Money market funds are a truly remarkable chapter in the 

history of U.S. mutual funds. Initially, they were used as savings 

vehicles. Today, retail and institutional investors alike rely on 

them as a broader cash management tool because of the high degree of liquidity, stability, of principal value and current yield that 

they offer. ICI estimates that between 1980 and 2004, roughly $100 

trillion, a staggering number, flowed into, and the same amount 

out of money market funds. 

Now if the money market fund industry is a success story for Institute members, money funds are also, most certainly, an SEC 

10

success story as well. Since 1983, money market funds have been 

governed very effectively by Rule 2a-7 under the Investment Company Act of 1940. Rule 2a-7 limits the types of securities in which 

money market funds can investment in order to help them achieve 

the objective of maintaining a stable net asset value of one dollar 

per share. Credit ratings form an integral part of these limitations. 

For example, money market funds may only invest in securities either rated by an NRSRO in its two highest short-term rating categories or if the securities are unrated, they must be determined 

by the fund’s board of directors to be of a quality comparable to 

such rated securities. 

Now it is important to note that no Government entity, such as 

the FDIC, insures money market funds. Nevertheless, despite an 

estimated $200 trillion flowing into and out of these funds over the 

past 25 years, through some of the most volatile markets in our 

history, only once has such a fund failed to repay the full principal 

amount of its shareholders’ investments. In that case, many years 

ago, a small institutional money fund broke the buck due to extensive derivatives holdings. 

It is critically important that this record of success achieved 

under Rule 2a-7 continues for the benefit of money fund investors. 

This, in turn, depends upon the ratings issued by NRSROs providing credible indications of the risk characteristics of those instruments in which money market funds invest. 

To promote the integrity and quality of the credit ratings process 

and, in turn, serve the interests of investors who use credit ratings, 

we believe that there are several steps that should be taken. First, 

the NRSRO designation process should be reformed to facilitate the 

recognition of more rating agencies and, thereby, introduce much 

needed competition in the credit rating industry. 

The mutual fund industry is one in which intense competition 

has brought unparalleled benefits to investors. I firmly believe that 

robust competition for the credit ratings industry can do the same 

and is the best way to promote the continued integrity and reliability of credit ratings. Unfortunately, the current designation 

process does not promote but, in fact, creates an affirmative barrier 

to competition. In particular, the current SEC process for designating credit rating agencies through the issuance of no action letters has not worked effectively. In place of this no action process, 

the Institute recommends mandatory expedited registration with 

the SEC. We are, therefore, pleased that H.R. 2990 properly moves 

the basis for NRSRO designation from a national recognition standard to an SEC registration requirement. 

Second, there should be appropriate regulatory oversight by the 

SEC to ensure the credibility and reliability of credit ratings. We 

believe this can be achieved through a combination of one, periodic 

filings with the SEC and, two, appropriate inspection by the SEC 

coupled with adequate enforcement powers. Specifically, H.R. 2990 

would require that certain important information be provided to 

the SEC upon registration. We believe that NRSROs should be required to report to the SEC on an annual basis that no material 

changes have occurred in these areas. Similarly, NRSROs should 

be required to report any material changes that do occur on a timely basis, and this information should be made available promptly 

11

to investors who rely on NRSRO ratings. Such disclosures should 

be accompanied by an appropriate SEC inspection process tailored 

to the nature of their specific business activities. 

Third, investors should have regular and timely access to information about NRSROs to provide them a continuous opportunity to 

evaluate the ratings that they produce. In discussions with our 

members, they have emphasized the importance to them, as investors, of access to information about an NRSRO’s policies, procedures, and other practices relating to credit rating decisions. In 

particular, it would be helpful for NRSROs to disclose to investors 

their policies and procedures, addressing conflicts of interest, as 

well as the conflicts themselves, and periodically to disclose information sufficient for investors to evaluate whether they have the 

necessary staffing, resources, structure, internal procedures, and 

issuer contacts to serve effectively as NRSROs. 

Finally, we believe NRSROs should have some accountability for 

their ratings in order to provide them with incentive to analyze information critically and to challenge an issuer’s representations. 

Specifically, we believe that any reforms to the credit ratings process should, at a minimum, make NRSROs accountable for ratings 

issued in contravention of their own disclosed procedures and 

standards. Even if the First Amendment applies to credit ratings, 

it does not, in our view, prevent Congress from requiring rating 

agencies to make truthful disclosures to the SEC and to the investing public. 

Now the SEC has been aware of issues relating to credit rating 

agencies for over a decade now. During that time, it has issued two 

concept releases, two rule proposals, and submitted a comprehensive report to Congress addressing credit rating agencies and 

NRSRO practices. In the process, the Commission has received 

scores of comment letters, including several from the Institute, urging action in this area. No action has been forthcoming. In light of 

this history, we believe action by Congress is now necessary. The 

Institute strongly, therefore, supports the goals of H.R. 2990: increased competition, appropriate SEC oversight, greater transparency, and heightened accountability. These are the right objectives for reform of the credit rating industry from the perspective 

of mutual funds, other investment companies, and other investors, 

and, indeed, the securities market as a whole. 

I very much appreciate the opportunity to share the Institute’s 

views with you today. We have a number of technical comments 

about the bill that we will be providing separately, and we do look 

forward to working with the committee on these and other issues 

in the months ahead. 

Thank you, Mr. Chairman. 

[The prepared statement of Paul Schott Stevens can be found on 

page 68 in the appendix.] 

ChairmanOXLEY. Thank you, Mr. Stevens. Mr. Roberts. 

STATEMENT OF RICHARD Y. ROBERTS, PARTNER, THELEN 

REID & PRIEST LLP, ON BEHALF OF RAPID RATINGS PTY LTD. 

Mr.ROBERTS. Mr. Chairman, I appreciate the opportunity to appear today on behalf of Rapid Ratings. I am Rick Roberts. I am an 

attorney in Washington, D.C., with the firm of Thelen Reid & 

12

Priest. The views that I express today are to be considered my own 

and do not necessarily represent those of my law firm or the clients 

of my law firm. Matter of fact, if the views are not well received, 

I will disclaim them as my own after the hearing. 

From 1990 to 1995, I was privileged to serve as an SEC Commissioner. During my SEC life, in a couple of speeches in 1992, I highlighted what I viewed as the potential problems imbedded in the 

NRSRO designation criteria utilized by the SEC. First and foremost among them is that that acronym really stinks, and it needs 

to be a lot shorter. It is very hard to pronounce. Unfortunately, not 

much has changed since 1992. I believe that H.R. 2990 will introduce much needed competition and additional integrity to the rating process for debt securities and will reduce systemic risk in the 

marketplace. In my view, H.R. 2990 will serve as a catalyst for reforms that will greatly enhance the quality of information provided 

to investors. 

It may be helpful if I talk for a few minutes about Rapid Ratings. 

Rapid Ratings is an organization founded in 1997 and is an independent global corporate credit rating agency headquartered in 

Australia, with other offices in New Zealand, Singapore, the UK, 

Canada, and the U.S. Rapid Ratings is currently licensed by the 

Australian Securities and Investment Commission as a credit rating agency to provide financial advice to wholesale and retail markets. Rapid Ratings anticipates that it will file an application seeking to obtain NRSRO designation with the SEC in the near future. 

Using proprietary software, Rapid Ratings rates approximately 

15,000 listed companies globally, including 7,000 in the U.S. Rapid 

Ratings follows the original rating agency model of being paid by 

buy-side subscribers, rather than by issuers of securities. Unlike 

current NRSROs, Rapid Ratings credit ratings assess the financial 

health of an institution based on industry-specific quantitative 

models, and the ratings are derived solely from publicly disclosed 

financial statements. 

The current NRSRO criteria were designed for rating agencies 

with an issuer-paid business model, despite their origins of being 

paid largely by subscribers. Since NRSRO status was introduced in 

1975 for net capital rule purposes, the largest rating agencies have 

been increasingly and now predominantly paid by issuers of debt 

to rate those parties, and I refer to this as a Type 1 business 

model. This was, perhaps, one of the unintended consequences of 

the creation of NRSRO status. Type 1 rating agencies employ highly skilled and highly paid people that go onsite to acquire nonpublic information to rate companies. New generation rating agencies, such as Rapid Ratings and many others, have an entirely different business model, which I will refer to as the Type 2 model. 

New generation rating agencies are paid by investors or other 

buy-side third parties, such as banks, insurance companies, mutual 

funds, pensions funds, large creditors, et cetera, to rate second parties, such as listed and/or unlisted companies and their securities, 

and use only publicly available information. Type 2 rating agencies 

also typically use software rather than analysts. Thus, in the Type 

2 model, there may be no contact between the rating agency and 

the companies it rates and, thus, little potential for conflict of interest. In assessing eligibility for NRSRO status, it would be unfair 

13

to require a Type 2 company to conform to criteria that pertain 

only to Type 1 companies that have such conflicts. 

Now Rapid Ratings believes H.R. 2990 would achieve many of 

the goals that are necessary to promote greater efficiency in the 

debt markets. It would remove most of the current restrictions, instituting a registration process for rating agencies that have been 

in business for more than 3 years, and substituting ′′registered′′ for ′′recognized′′ in the NRSRO acronym. It also would permit quantitative firms to be registered and would allow subscription fees to 

be charged for ratings by not requiring wide dissemination of ratings at no cost. Thus, the legislation will ensure that the pre-1975 

practice of having the ratings largely paid for by investors and 

other buy-side subscribers is revived by new generation rating 

agencies with new technology and a strong record for providing 

early warnings to the market. This bill, if enacted, goes a long way 

toward removing the barriers to entry created by the current regulatory standards while assuring the integrity of the rating process 

by providing credible market-based standards. 

And in conclusion, I believe, as I always have, that regulation is 

no substitute for competition in the marketplace. Consumer choice 

is often the best policeman. In my opinion, the real potential for 

enhancing ratings competition arises with the entry of innovative 

rating agencies that offer alternate business models. If a level playing field is created to permit Type 2 rating agencies with innovative business models that are paid by investors to compete effectively with Type 1 rating agencies that are paid by issuers, there 

will be, in my judgment, significant benefits to the marketplace, 

and these benefits include earlier warnings to the market of potential problems, enhanced protection and choice for investors, greater 

accuracy in ratings, broader coverage of securities and issuers, 

lower costs to issuers and investors, greater independence and objectivity, and less risk of systemic shocks. In my view, the reduced 

barriers to entry afforded by H.R. 2990 will provide substantial 

benefits to the market and will improve the efficiency of the capital 

allocation process. 

Again, I appreciate the opportunity to participate in the hearing, 

and I will be happy to attempt to respond to any questions that you 

may have at the appropriate time. 

[The prepared statement of Richard Y. Roberts can be found on 

page 51 in the appendix.] 

ChairmanOXLEY. Thank you, Mr. Roberts, for your testimony. 

We now have Professor Macey. 

STATEMENT OF JONATHAN R. MACEY, SAM HARRIS PROFESSOR OF CORPORATE LAW, CORPORATE FINANCE, AND 

SECURITIES LAW, YALE LAW SCHOOL 

Mr.MACEY. Thank you. It is a pleasure to be here, and Chairman 

Oxley and Subcommittee Chair Baker and Congressman 

Fitzpatrick, I am delighted to be here. 

The previous four speakers did a great job and said a lot of the—

made a lot of the points I was going to make, so I will try to focus 

on some new and different aspects. But let me begin by saying that 

I think the statute proposed, H.R. 2990, provides a very valuable 

legislative framework that will promote more vigorous competition 

14

in the rating agency business and provide not only better ratings, 

but also provide strong protections for individual investors. I would 

add to that that I think the statute is very simple, elegant, well 

tailored to the problem, so I think that it is something that I 

strongly support. 

There is this strange puzzle in the—those of us who study credit 

rating agencies often observe, which is, as was pointed out earlier, 

we see an industry that makes tremendous amounts of profits, but 

at the same time, seems to do a really bad job, as we see with respect to the performance of rating agencies in contexts like Mercury Finance, Orange County, Pacific Gas & Electric, Enron, 

WorldCom, and more recently, the lagging ratings for companies 

like General Motors and Ford. And I think that there was nothing 

unintentioned, or there is nothing intentioned, rather, or evil in the 

way this developed. I think it was basically inadvertent that the 

NRSRO designation evolved in such a way that it created an artificial demand for ratings and people in the financial marketplaces, 

as was the case with the example earlier of Rule 2a-7 of the Investment Company Act of 1940. It created a demand for ratings regardless of the content or quality of those ratings. We have very little 

competition in that area. 

So I fully support this statute. I want to just say in a couple of 

additional points. One is while I certainly agree that there have 

been drastic improvements in—since the sort of Enron era, I don’t 

think it is the case that the credit rating agencies are the only sort 

of noncompetitive node in the capital markets, that the GAO has, 

I think, amply demonstrated the lack of competition among the remaining four accounting firms for auditing large U.S. companies, 

stock exchange specialist firms, bulge bracket underwriting firms. 

Self-regulatory organizations in the financial markets are also like 

the current NRSRO situations where in a perfect world we would 

spend time thinking about how to make those areas of the capital 

markets more competitive. The nice thing about the credit rating 

agency problem, if you will, is that we have before us a very, I 

think, discrete functional solution, and it is a terrific, terrific place 

to start. I would just urge this committee to continue down this 

very good path towards making capital markets more competitive. 

A couple of other points. One is on the First Amendment issue. 

Let me just say that generally speaking, I think this is a complete 

red herring. If this statute violates the First Amendment, then I 

think the Securities Act of 1933 registration requirements for initial public offerings also violates the First Amendment, so we could 

stop IPOs. I don’t think either one of them does. I think that is 

simply a red herring put forth by people who want to, for obvious 

economic reasons, to maintain the current status quo. 

One kind of footnote to that is, one aspect of this statute would 

prohibit the newly created registered rating organizations from 

issuing unsolicited or free ratings. I think that, given the other 

changes in the bill, I am not sure that is necessary. I do agree that 

unsolicited ratings are a very big problem. There is this issue of 

whether rating agencies engage in shakedowns of companies and 

municipalities in the market for credit. Do agencies demand payment by companies and municipalities for ratings? If that is the 

case, I certainly think that there should be regulatory action taken 

15

against the rating agencies. I also think that rating agencies 

should be required to disclose when the ratings they issue are unsolicited, and they should also be required to disclose when they 

are offering services on a fee basis to the entity being rated, but 

were declined, and I think that the agencies similarly should be required to disclose whether information on which their ratings are 

based is as complete in the case of an unsolicited rating as information that they ordinarily possess when generating a solicited fee 

paid rating. But I am not sure I would go as far as the legislation 

goes and require—and ban unsolicited ratings. 

Last is, I certainly support specific features of the legislation that 

would require disclosure of conflicts of interest and the procedures 

and methodologies used in determining ratings, as well as the procedures used to prevent the misuse of nonpublic information. I 

would be—certainly, though, you would want to—we would want to 

be careful in implementation that, to the extent that companies 

have developed proprietary trade secrets, which would be of use to 

rivals, with respect to the ways that financial data is analyzed, and 

for the generation of a rating, we would want to protect that property right. 

But with that said, I think—excuse me, 2990 is an important and 

valuable statute, which I will hope will pass, and will improve the 

quality of the information provided by credit rating agencies and 

establish credit rating agencies as an important component in the 

U.S. system of corporate governance and investor protection. 

Thank you. 

[The prepared statement of Jonathan R. Macey can be found on 

page 37 in the appendix.] 

ChairmanOXLEY. Thank you very much, Professor. And our final 

witness is Mr. Sean Egan. Mr. Egan. 

STATEMENT OF SEAN EGAN, MANAGING DIRECTOR, EGANJONES RATING CO. 

Mr.EGAN. Thank you. I am Sean Egan. I am managing director 

of Egan-Jones Ratings. 

We support the proposed legislation for reforming the rating industry, since it significantly increases competition. 

The primary purpose of rating firms is to facilitate the allocation 

of capital by assessing the relative riskiness of various issuers. The 

job can be compared to the trucking industry, in the sense that 

capital, rather than goods, are moved throughout the financial system. Unfortunately, the regulatory process for the trucking industry makes a great deal more sense than does the regulatory process 

for the rating industry. In the trucking industry, there are various 

tests drivers need to take to ensure that they are able to operate 

vehicles in a safe manner. The tests are straightforward, and passing them is similar to passing a driving test. In the rating industry, 

there has never been a formal process for obtaining a license, and 

at the current rate, there never will be. Regulators have been 

studying the area since the early 1990s and have yet to establish 

a set of requirements for applicants. Yes, two firms in the past couple of years have been recognized, but for the most part, the firms 

provide little competition to the major firms in the industry, S&P 

16

and Moody’s. DBRS rates mainly Canadian issuers, and AM Best 

focuses on insurance firms. 

In the trucking industry, if a shipper is unhappy with the rates 

or service of one particular shipper, there are a variety of other 

shippers available. In contrast, in the rating industry, there is relatively little competition. S&P and Moody’s garner approximately 

85 percent of the revenues for U.S. corporate debt, and a rating 

from two firms is normally needed for a public issue. The costs for 

the lack of competition is borne by issuers, investors, employees, 

retirees, and non-recognized rating firms. 

To address some of the concerns that have been raised about 

H.R. 2990, facilitating the emergence of a plethora of unqualified 

rating firms, we recommend the following additions to Section 3(a) 

of the Act—of the bill. 

Independence. No NRSRO shall be affiliated with a broker-dealer, bank, financial institution, issuer, investor, or user of credit ratings. Experience. The rating firm shall have issued ratings for the 

past 7 years and shall have generated at least $1 million in revenues from such activities in the U.S. for a period of 7 years or 

more. Quality. To reflect the impact of events such as acquisitions, 

major share repurchases, and buyouts, all ratings issued will be reviewed using qualitative methods. Additionally, the NRSRO shall 

be available to issuers’ personnel and capable of reflecting issuer 

comments in ratings. Note, credit ratings based on security prices 

and spreads can be easily manipulated and provide profit opportunity to unscrupulous investors. 

Regarding objections to H.R. 2990, below are rebuttals. H.R. 

2990 does not disrupt the markets. Increased competition should 

improve market conditions. H.R. 2990 does not violate First 

Amendment. Additional competition should not affect First Amendment protections. H.R. 2990 does not promote rogue firms. Additional competition should encourage the issuance of timely, accurate ratings. 

Moving forward on this issue is critical. We are all aware of the 

problems caused by the faulty ratings of WorldCom, Enron, and 

other failed issuers. However, less obvious are the problems caused 

by underrating firms, such as Nextel. As can be seen in the attachment, we rated Nextel at BBB-, as of November 2003, when S&P 

rated the company at BB-, and Moody’s at only B2. The difference 

in cost between a BBB- rating and a B2 rating is approximately 

300 basis points, or 3 percent. Nextel had $10 billion of debt at the 

end of 2003. The additional cost is $300 million per year of these 

faulty ratings, $300 million is the amount greater than the earnings of most public firms. By the way, both S&P and Moody’s 

raised their rating to investment grade in August of 2005. 

Thank you for your time and interest. Attached is additional information on Egan-Jones. 

[The prepared statement of Sean Egan can be found on page 30 

in the appendix.] 

ChairmanOXLEY. Thank you, Mr. Egan, and thank all of you gentlemen for excellent presentations. 

Let me begin with a few questions. One of the critiques that we 

have heard over the last few months regarding Congressman 

Fitzpatrick’s legislation is there will be—this legislation would lead 

17

to rating shopping, with the rogue firms jumping up and lowballing 

and the like, creating perhaps an artificially competitive marketplace. Are those criticisms justified, and let us just begin with Mr. 

Reynolds and go to my left to right. 

Mr.REYNOLDS. Well, it is, excuse me, it is certainly not without 

past history. That was something that was done in the money market business in the ’80s, where, with all due respect to some of the 

roll ups, the idea was if you couldn’t get Moody’s and S&P over 

from an A to a P to a 1 rating, you’d go shop at Fitch and Duff 

to get the Def One F1, so, you know, that is a pretty benign form 

of it. I think the way the reform is more likely to play out is you 

are going to have more companies entering the space using investor-based models, not issuer-based. Because right now, there is a 

stranglehold on the issuers, and, frankly, the issuers will have a 

very hard time going to smaller organizations that are just on the 

way up. So it is not going to be the issuer that drives the reform. 

It is bringing high information content, high quality ratings to investors, and they are certainly not looking for anything other than 

good input to manage their risks. So I think that is a real risk, but 

I would say that is the one in 10 piece of the equation. The nine 

in 10 is how do you build a revenue model, how do you build a firm 

of scale, and in order to do that, you are going to have to go to the 

investors, not the issuers. 

ChairmanOXLEY. Mr. Stevens. 

Mr.STEVENS. For various purposes, mutual funds, as investors already have to do independent credit analysis. They can’t simply 

rely on ratings. What we would like to see the legislation do, Mr. 

Chairman, is to provide much more information about the ratings 

agencies and their processes so that we can assess the quality of 

the ratings that they are producing. There is no incentive that I 

can see for a mutual fund investor to rely upon or to shop for bad, 

poorly produced ratings. Quite the contrary. But as institutional investors, if they have access to the information, they can make judgments about the quality of the ratings agency and what they are 

producing, and I think then, they will go to the strongest and best 

ratings to utilize in making their investment decisions. 

ChairmanOXLEY. Mr. Roberts. 

Mr.ROBERTS. Well, I don’t believe that there is that much risk 

with respect to the issue of ratings shopping. First of all, as Mr. 

Reynolds indicated, any organization has to worry about its 

reputational risk, and the marketplace should be able to discern 

pretty easily, through readily available performance benchmarks, if 

someone is systematically an easy grader. There are ample, 

verifiable statistical measures, such as default statistics and rating 

comparisons on issuers rated jointly by multiple agencies, which 

should reveal any such easy grader pretty quickly. In my judgment, 

this concern is probably already addressed in the marketplace, 

where market pricing mechanisms such as bond spreads routinely 

second guess the credit rating and would highlight firms that are 

consistently assigning higher ratings than would be warranted by 

an issuer’s financial condition. So I would consider the risk fairly 

slight, certainly as compared to the benefits of competition. 

ChairmanOXLEY. Professor Macey. 

18

Mr.MACEY. I agree with what Mr. Roberts just said. I would add 

to that that given the prominence of institutional investors in today’s investing world, my inclination is that new entrants into the 

credit rating game are going to be extremely concerned about 

screwing up and giving a high rating to somebody that, like to a 

company, that later implodes and getting branded with the sort of 

moniker of being too easy. So I think the market will take care of 

itself, with the institutional investor community being able to sort 

out the new entrants that are providing valuable information and 

ignoring those that are engaged in the sort of race to the bottom 

that was just suggested. So I am not—I think it is—that we will 

see much better quality ratings, and we will see pressure that we 

don’t observe now on firms to compete along the vector of quality. 

ChairmanOXLEY. Professor, if I could—let me digress just a 

minute because in your testimony— I have got to do this before I 

think of it; otherwise it is gone. That is just the way my mind 

works. I was in law school a long time ago, so I am trying to come 

back to this. But anyway, your testimony was regarding the accounting firms and the lack of competition now that we are down 

to the final four. I wonder if you could help us through that. How 

do we create an atmosphere in which we create more competition 

and get back to what used to be the Big Eight, or at least some 

semblance of that? How do we recreate that, or can we, and what 

are the prospects? 

Mr.MACEY. Well, just to be clear, it is easy, in my view anyway, 

to explain why we have no competition or very little competition in 

accounting, and I want to make it clear also that according to the 

General Accounting Office, the level, the lack of competition is 

much worse than is suggested by the fact that there are only four 

accounting firms. Because if you look at the level of specialization 

in the accounting industry, so you have these accounting firms that 

are focusing on aerospace, or focusing on biotech, that, in fact, companies in those industries may really, as a practical matter, after 

the demise of Arthur Andersen, only have a couple of firms to 

choose from. So it is really bad. 

Now the reason that we have this problem is very similar in 

many ways historically to the reasons we have this credit rating 

problem, which is it is, if you will forgive me for saying so, a little 

largely attributable to what has turned out to be misguided regulation by the SEC, the NRSRO designation, in this case. With the 

case of accounting firms, the problem is in order for an accounting 

firm to qualify to regulate a company, it has to be the earning, the 

income that the accounting firm makes from the audit business has 

to be a small percentage of the audit firm’s overall revenue, which 

means that you have to be a giant accounting firm, like Arthur Andersen, to qualify to audit a firm like Enron because, otherwise, 

your billings to Enron will be too big of a percentage of your overall 

earnings. 

My own view, based on empirical work in the accounting industry, which I would be thrilled to discuss with you, suggests that the 

way that we ought to get rid of that regulation, and we ought to 

allow little bitty accounting firms, smaller accounting firms, the 

non-Big Four, and I will add, you know, the drop-off after the Big 

Four is pretty steep, to get into the business of auditing big compaVerDate 0ct 09 2002 10:49 Jun 01, 2006 Jkt 000000 PO 00000 Frm 00024 Fmt 6633 Sfmt 6633 G:\DOCS\109.66 RODNEY
19

nies, bearing in mind that I think this percentage test for independence is meaningless. As we saw with Arthur Andersen, what 

really mattered from the standpoint of the independence of the auditing firm wasn’t Arthur Andersen as a company; it was the audit 

engagement team that was actually doing the work, and there, you 

had this guy David Duncan, and he didn’t do anything else but 

Enron, and he lived at Enron, and he basically took, acted in many 

ways like an Enron employee. 

A statute you undoubtedly are aware of, the Sarbanes-Oxley Act, 

deals with that to some extent, with the auditor rotation provisions, and I would suggest as an add-on to that that we relax these 

independence restrictions so that we could open up competition in 

the accounting business for the largest U.S. companies, beyond just 

the final four accounting firms that remain. 

ChairmanOXLEY. Thank you. Mr. Egan. 

Mr.EGAN. I have to differ with the other panelists. We think it 

is a huge problem, and let me explain why. Approximately 90 percent of the revenues in the rating industry are generated by the 

issuers. People respond to the money, and there is no reason why 

you wouldn’t have rogue firms emerging that are giving very generous ratings. It would be difficult to prevent that. 

An extreme example would be, under the current Act, an underwriter can form a rating firm. It could be under the underwriter’s 

name, Merrill Lynch Ratings, or it could be an affiliate of Merrill 

Lynch, and could say, ′′Come to us. Don’t worry about the ratings; 

we will take that. Yes, we will go to S&P and Moody’s because they 

have been there forever. We will take care of the ratings. And by 

the way, there will be a fee for that.′′ There is little that can prevent that under the current Act. 

If you look at the business, there is about $6 billion in revenues. 

Over $5 billion of it is generated from issuer compensation. So I 

think the fear of the emergence of rogue firms is very real, and it 

makes sense to set up some protections against that. In my testimony, I used the analogy of trucking firms or drivers. The credit 

rating market is fundamentally different than the investment advisory field. You don’t want drunk drivers on the road. You don’t 

want inexperienced drivers on the road. It is too important. Why 

is it important? Because a lot of parts of the regulatory system rely 

on these ratings. I think you want to have some initial checks. If 

firms don’t abide by it, like S&P and Moody’s should have been put 

on some kind of probation as a result of the Enron, WorldCom ratings, and that didn’t exist. There should be some kind of checking 

system, but before they even get on the road to issue these ratings, 

there should be some tests. 

ChairmanOXLEY. Thank you. Mr. Reynolds, you indicated in your 

testimony that the bill needed definitional tweaking. What were 

you suggesting? 

Mr.REYNOLDS. In particular, just the area between ratings and 

investment advisory work. It gets greyer by the day, and it is—for 

example, I mean, we are investment advisor. The fact that we 

would probably say buy, hold, or sell on some securities is an aspect that would make us want to do that, so we did that. With the 

rating agencies, they have always been very clear that they stop 

short of that, and there is quite a bit of a blurring here, not only 

20

how they operate today, but also really how it is construed in the 

marketplace. It is the form versus substance debate. They have 

launched a product recently, for example, Moody’s has, called market implied research strategies. They frame their ratings against 

where securities are trading, or where derivatives are pricing risk, 

and it is presented with, as a contrast. If they don’t say buy, hold, 

or sell, but it is just about the same thing, it will take you right 

to the doorstep, and everyone sees it who uses that product for 

what it is, and there are other products like that as well. You 

know, you are the third base coach in baseball signaling the guy 

on first to steal second. You don’t have to scream steal, you know; 

you just tip your hat. The rating agencies are doing the exact same 

thing. They are in the advisory business in substance, if not explicitly in form. 

So one of the aspects of the bill that was a little murky for me 

around investment advisor versus NRSRO, and there are quite a 

bit of overlaps that people should be sensitive to, and it is just a 

little more drilled now in clarification of how companies typically 

operate. Everyone talks about default risk as the main issue. The 

great bulk of assets and risks that is managed out there, it is not 

about default risk. It is in terms of perception of default risk, but 

mostly, it is about short term, rapid changes in the risk that affect 

portfolio performance and the result and losses being realized. As 

this, you know, I know I am overdoing the sports metaphor, but 

the great bulk of the activity in the credit markets takes place between the 20 yard lines, not in the end zone. The end zone would 

be a default. Default risks are historically very low, but credit volatility historically can be very high, and that is where investors are 

harmed, because of short term, sudden changes that drive losses. 

And that is where that investment advisory and NRSRO designation starts to overlap, and that probably should be worked on a bit. 

ChairmanOXLEY. Thank you. The gentleman from Louisiana. 

Mr.BAKER. Thank you, Mr. Chairman. 

I want to return to Mr. Egan and the response to the chairman 

relative to the potential for creation of rogue firms. It would seem 

from your comment that there should be some requirement that a 

firm must meet beyond registration in order to engage in the practice, which might be just a slightly different standard than what 

we have today, as opposed to a registration and a free market driven system, which would enable a participant to enter without necessarily establishing credentials. Am I understanding your objections correctly, or is there a slightly different view? 

Mr.EGAN. Yes, there should be some credentials before someone 

enters. As it is currently written, anybody, my son, 10 years old, 

he can be issuing ratings and become a rating firm and—

Mr.BAKER. But do you think an issuer is going to pay your son 

a fee? I mean—

Mr.EGAN. No, he’s not going to receive a fee, but that is an extreme example, but it could be something like Merrill Lynch, who 

wants to get as much market share as they possibly can underwriting, set up their own or another rating firm, you know, that is 

affiliate and facilitate the underwriting process. 

Mr.BAKER. Well, I take your point, worthy of further examination, but it seems to take me back to the dark days of the investVerDate 0ct 09 2002 10:49 Jun 01, 2006 Jkt 000000 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 G:\DOCS\109.66 RODNEY
21

ment banker analyst issues and how one prescribes a system that 

allows the two to simultaneously coexist, but provide disclosures to 

the ultimate users of information, or judges of risk, about how a 

particular decision is being made so that if there is a particular unusual relationship between Merrill Lynch Ratings and a Merrill 

Lynch issuer activity, that those disclosures would help, in some 

measure, address it. My concern is that if we go to a hard and fast 

standard of entry, we are replicating in just a little bit broader 

methodology that we have today. Today, we are calling it artwork. 

We don’t know what one is, but when we see it hanging on the 

wall, we see you are a rating agency. We might want to describe 

the frame. We might want to describe the colors. We might want 

to have the artist’s name checked off, but we are really just going 

to have a little bit broader mechanism than we have today. If we 

really go to some sort of undescribed set of standards that one 

must meet. Perhaps, your suggestion of some criteria of time in the 

market—

Mr.EGAN. I think that makes sense. I think money talks. I think 

a certain revenue base makes a lot of sense. I think that the fundamental problem that we have right now is that you have two firms 

that are really, and have exerted a lot of influence in this process. 

There are other firms that do qualify, that do issue credible ratings, and have not been able to get the NRSRO designation, for a 

variety of reasons. Unfortunately, the current regulators aren’t 

willing to state what the problems are, why their applications 

haven’t been approved or disapproved, or what even the status of 

the application is. Bringing it back to the driver analogy, you need 

to have some fundamental tests because it is too dangerous to the 

market to go from the current market structure right now to wide 

open whereby anybody is allowed to shoot any game they want to. 

You need some levels of credibility, and I think being in the market 

for a couple market cycles makes perfect sense, and having a minimal level of revenues from the activity makes a huge amount of 

sense. It also makes sense to exclude certain affiliated firms. It 

makes no sense for a bank to be allowed to generate their rating 

firm because it opens the system to abuse. It makes no sense for 

an underwriter to be allowed to set up a rating firm. So—

Mr.BAKER. I don’t disagree. I am merely trying to bore down a 

little bit. 

Mr.EGAN. Right. 

Mr.BAKER. Get a better understanding as to your driver example 

and not letting your 10-year-old son drive. It would be just as advisable not to have an 80-year-old grandmother who no longer can 

see. 

Mr.EGAN. Absolutely. 

Mr.BAKER. Even though she has been driving for 50 years. 

Mr.EGAN. Right. 

Mr.BAKER. The consequences could be the same. But Mr. Stevens, you made a note in your testimony, the NRSROs should have 

some accountability for their ratings in order to provide them with 

an incentive to analyze information critically, and then I am not—

I am just pointing out that you raised a very important issue. Then 

Mr. Roberts, in your testimony, you talk about output criteria 

should be the measurement that we use, for example, ability to anVerDate 0ct 09 2002 10:49 Jun 01, 2006 Jkt 000000 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 G:\DOCS\109.66 RODNEY
22

ticipate corporate demise ahead of the necessary deterioration of 

share price. Then, you go on talking about the qualities of the Type 

2 agencies that mark-to-market using software models often paid 

for by the buy side, which have track records of issuing early warnings and objectivity, and then I wind up back at the professor, who 

states that you oppose the disclosure of the requirements of telling 

someone how you go about issuing your ratings. It seems across the 

three of you, we go for a need to have disclosure and accountability 

so that the market can look at a rating agency’s set of performance 

standards, then we go to Mr. Roberts’ output measurement criteria 

to say this is how we are going to look at you and, therefore, hold 

you accountable. What is wrong with some sort of generic disclosure? I understand proprietary business formula not being necessarily put on the street, but if I am going to be the end user of 

the rating to make a risk judgment, shouldn’t I have some appropriate disclosure of how they go about doing it? Professor. 

Mr.MACEY. Yeah, let me just say I agree with that, the generic 

disclosure, as long as there is not any proprietary information. 

With respect to the sort of—the problem of this rogue, or rating 

agencies popping up like mushrooms in the wake of the statute, I 

want to—it seems that—it is important to realize that if this statute were enacted, we would be in a much different world, in the 

sense that we would be—we would no longer be in the current situation where companies are only permitted to invest in a wide variety of circumstances under both Federal law and various State 

laws, particularly insurance laws, in companies that lack this 

NRSRO ratings, so that the vector along which these organizations 

would compete would be a vector of quality, and to be frank, I appreciate Mr. Egan’s frankness in sort of engaging the discussion. I 

don’t really, with all due respect, sort of buy the car analogy because if there is some underage driver, or unqualified driver, he 

poses a risk to other people on the road, so you have this sort of 

externality problem that makes sense to regulate. If I am—if I exhibit sufficiently bad judgment that I make an investment decision 

on the basis of a rating from a rating agency with a poor track 

record or that is one of these rogue ones that we are concerned 

about existing, I internalize that problem. It is not as though I am 

in the car running someone else over. This is, in the world that we 

are going to see in the wake of the statute, if it passes, and I hope 

it will, then the people who make bad judgments with respect to 

utilizing bad rating agency information are going to internalize 

those costs in a free market in exactly the same way they are going 

to internalize the cost of getting bad investment advice from a 

broker or something of that nature, and I think that the markets 

will do a very good job in sorting out the good ones from the bad 

ones. 

Mr.BAKER. Mr. Chairman, I have just got one more follow up. 

Mr. Stevens, you mentioned the—holding the rating system accountable in some form or fashion. Do you share the view that has 

been described by Mr. Roberts, outcome analysis as an appropriate 

measure of enforcing accountability, or how would you view a system that would be appropriate to create that accountability? 

Mr.STEVENS. Well, outcome analysis is important information to 

have in the market so that the people who are looking to use a parVerDate 0ct 09 2002 10:49 Jun 01, 2006 Jkt 000000 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 G:\DOCS\109.66 RODNEY
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ticular rating agency or particular rating, have some sense of what 

the track record has been. When I referred to accountability in my 

testimony, it was really accountability of the nature that contemplated that if a ratings agency says here is my process, this is 

what I do, then they are to be held to do that. If, for example, they 

say we don’t really simply rely upon publicly available information. 

We go and do research on the premises. We talk to the officials of 

the company. We kick the tires in other ways as well. And if they 

then produce a rating where they haven’t done that, that they really were relying on a smaller universe of information, it seems to 

me they ought to be liable and accountable for having misrepresented their process. 

This notion of proprietary methods, I think, is a little overstated, 

with all respect. We deal with this issue in disclosures all the time. 

Corporations that are seeking to raise money in the marketplace 

will talk about business systems, business activities, business 

methods. There is a line that you can draw between what is truly 

proprietary and what is informative, detailed disclosure—I 

wouldn’t call it generic; that suggests boilerplate. It can go into 

greater detail that that. So I think that is a line that we can draw. 

If I might, Mr. Chairman, just add one other thing to this question about the drunk driver, the point I am making is, from the 

perspective of an investor, if you can administer the breathalyzer, 

right, and you can determine whether the driver is drunk, you can 

make a decision about whether to pile into the vehicle or not, and 

that is the value of disclosure in the marketplace. I see no reason 

why, well, there have to be changes in the way in the SEC has 

written 2a-7; I see no reason why a mutual fund firm that offers 

a money fund and has its franchise and its reputation on the line 

is going to be attracted to a schlocky ratings agency. There is going 

to be a tremendous attraction for the ones with the best track 

record, the best methods, and the greatest reliability and integrity 

in the market because the reputation and the dollars, essentially, 

the wealth of the firm, is going to be on the line in that process. 

Mr.BAKER. I take your point, and I only one I had entering into 

the new methodology and how we start it up is probably so critical 

because if we have missteps in the early days, it really makes recovery in the out years much more difficult. To put a personal experience in the discussion, yesterday, when we were flying in, we 

thought we had made it, and everything was fine, and we were 

going to get on the boarding door, and the pilot comes on and says 

he pulled up about 5 feet too far, and they are going to have to 

bring a tug out and push us backwards. If I had known my pilot 

was going to miss my boarding door by 5 feet, I probably would 

have elected another flight. You don’t want to find that out at your 

arrival gate. You really want to know, did he run over the dog 

when he came to pick me up, or do you keep it on the highway. 

I think that is really the issue right now. I want to get to this outcome based analysis. That means you have a record. That means 

I can look at what you’ve been doing. The problem is from where 

we are now to how do we get there, and I am not yet fully conversant with the remedy that gets us past that, but I certainly want 

to go where each of the witnesses have indicated they would like 

to see us go. 

24

I yield back, Mr. Chair. 

ChairmanOXLEY. The gentleman from Pennsylvania. 

Mr.FITZPATRICK. Thank you, Mr. Chairman. 

Mr. Reynolds, I appreciate your references to the history of the 

city and Constitution, and in your written testimony, you are referring to some of the players out there that wouldn’t be interested 

in the success of H.R. 2990, specifically those who want a little less 

free speech, and what you say is as it stands now, Moody’s and 

S&P seem to be saying Congress shall make no law respecting an 

establishment of competition to the NRSROs. 

With respect to the NRSROs, can you describe how they may be 

using their protected status to get involved in other business lines, 

including some of those lines that your firm, CreditSights, is involved in? 

Mr.REYNOLDS. They are probably coming as close to the line of 

being an investment advisory business as they have ever been, and 

partly, that is a response to building revenue. I have heard a lot 

today about different rules and regulations, but at the end of the 

day, it is about building revenue, whether you are at Moody’s or 

you are at a startup, whether you are taking it from—we have 

been in business 5 years; we went from eight to a hundred people, 

and it is painstaking work, reinvestment, but you have to have a 

viable product, and someone writes you a check for it. If they write 

you a check for it, it is real, and if they are a sophisticated investor, you are getting warm. And the same thing for Moody’s, when 

they want to continue to grow their top line, to drive their stock, 

and it certainly has done quite well, they have to find new ways 

to get out of the ratings areas, so they bought KMD; they have 

been buying content assets up. They recently bought a group of 

economists. They will continue to buy assets in because at the end 

of the day, they are a research firm, a ratings agency, but they are 

also in the content business, and they have to grow and leverage 

that fixed cost base. So they are pushing into a lot of different ancillary businesses, which are meaningful businesses, and how do 

you reach the equity, the stock analysts for example, with credit information? 

As we saw in the last 5 years, turns in the credit market can 

drive the equity performance of different names, so they are trying 

to figure out ways to go after all different types of investors using 

their basic infrastructure and making select investments, so they 

are in the investment advisory business in substance. They know 

it. The market knows it, but they need to run a story line because 

they have to plan their legal defenses. They are doing everything 

but stopping short of saying sell, and they are doing that by trying 

to be also more relevant to the market. One of the criticisms, say, 

10 years ago, was well, you are just a rater, there is low information value, and some of your earlier panelists in past hearings have 

testified on the low information content of ratings. So the way you 

crack the line up is you get into the information intensive business, 

something that a powerful institutional investor, or a bank, or a 

brokerage house will write you a check for. That is how you build 

a business. It is the economic reality of growth for all of these companies, and I think that Moody’s and S&P clearly are getting that. 

KMD was obviously a big landmark transaction, getting into deVerDate 0ct 09 2002 10:49 Jun 01, 2006 Jkt 000000 PO 00000 Frm 00030 Fmt 6633 Sfmt 6633 G:\DOCS\109.66 RODNEY
25

fault risk analytics. They keep that separately housed. But they 

are into the consulting business, for example. They are into economic forecasting. They are into all the same things the Street has 

been into for years, except it is not as NASD framework. So that 

is just a fact; I mean, people know it. It is like an ill-kept secret 

from X rating agency, and they will say, they will chuckle about 

the First Amendment discussion because they know that it is really 

not the main issue. They just want to stay free clear of any encumbrances and go back to the business line strategy. There is a reason 

why a lot of people want to get in this business. Moody’s has 55 

percent profit margins. That is just mind-boggling of pretax margins. The accounting firms don’t have that, so there is a reason 

people don’t want to get in the accounting business, but do want 

to get in this business. And also, at the end of the day, they are 

not staying up late at night worrying about CreditSights, Rapid 

Ratings, or Egan-Jones. In a way, we are all boutiques in the context of what they do. They are worried about Thompson, 

Bloomberg, Fax, Bertelsmann, Morningstar; these are the guys who 

will be stepping in, so the more barriers you put for their entry and 

their acquisitive activities, the more it is that Moody’s and S&P 

will be the same old duopoly 5 years from now. So be cognizant of 

the fact that it takes a lot of capital, a lot of resources, a lot of 

mergers, and a lot of activity the next 5 years to even mount a viable competitor against a group of people who have dominated the 

industry with what are increasingly higher natural barriers to 

entry. So I am a firm believer in letting the market work, and if 

Fidelity or Imgo or these top debt shops will pay you for your service, I think you have passed a test that the SEC is less qualified 

to opine on than people who live and breathe that business day in, 

day out, and have responsibility for a lot of retail assets. So I would 

say competition is better and quality is better. Constraints impact 

both in the wrong way. 

Mr.FITZPATRICK. Do any of the other panelists want to comment 

on that? Professor Macey, I think you were—you have spoken 

about the First Amendment issues, as one of the NRSROs, I think 

it was S&P, it seems to be the loudest about the impact of this potential legislation on their First Amendment rights. You went right 

to the ledge of saying why you think they may be raising that 

issue. Do you want to expand on that at all? 

Mr.MACEY. Well, as I said, with the exception of the provision 

that would prohibit unsolicited ratings, there is nothing in this that 

has the remotest impact on free speech. I think that, you know, if 

I were a paid consultant for S&P or Moody’s, you know, I might 

play the First Amendment card because it gets people’s attention. 

It slows the process down. And it seems to have been—it seems to 

be the case that the process slowed down quite a lot. Mr. Reynolds 

and I were—testified together before that Senate committee—I 

guess it was a couple of years, 2 or 3 years ago now—and we are 

still working toward some resolution of this issue. So, I mean, as 

I, you know, I don’t think that there is a—I don’t think there is 

a respectable argument. I think a lot of the things we have talked 

about today, Mr. Egan’s point is perfectly respectable that, you 

know, this is a concern about, I don’t happen to agree with it myself, but it is certainly a respectable argument to say you know, we 

26

are worried about quality of the new entrants and the issues about 

disclosure that Mr. Stevens is raising quite—I may come out a 

slightly different place, but quite respectable. The First Amendment issue is, in the context of the development of the securities 

laws in the United States and the high premium that we put on 

disclosure and investment, investor protection, this is really—this 

doesn’t even ruffle the waters in the pond with respect to First 

Amendment concerns. I think it is purely a tactic to impede the 

progress of legislation that would improve the competition in this 

industry. 

Mr.FITZPATRICK. To that issue of, I guess, Mr. Egan’s concerns 

about his 10-year-old son issuing rating, getting recognized. I 

mean, the statute, the bill as written does require 3 years background and does require disclosure of short term and long term 

performance statistics, so if you are in the business for 3 years, and 

there are benchmarks, and you are reaching those benchmarks, as 

Chairman Baker says, you know, if somebody is willing to pay your 

10-year-old son, wouldn’t it be discriminatory, if your son was only 

10 years old and they—

Mr.BAKER. We have this freedom of speech, I think, is what you 

are talking about. 

Mr.FITZPATRICK. If you are doing a great job, I mean, you 

wouldn’t want to prohibit your 10-year-old son genius from being 

involved in this business. 

Mr.EGAN. Maybe he can get it right. However, I think that this 

NRSRO designation is too important. It is used in too many different areas of financial markets, and I think more than 3 years 

is needed. I think you need some kind of market test, and a revenue based test isn’t a reasonable way. I think you have to exclude 

some firms that have an inherent conflict, such as underwriters becoming rating firms, or having underwriting affiliates, or major investors, or banks, or insurance companies. I think that there are 

some—to go from where we are right now to a more competitive 

market, you have to be careful in the way you take those steps. It 

would be foolish to open it up to anybody who applies after a 3-

year waiting period. It makes—that doesn’t—it would hurt the 

market too much. It is too great a risk. Yes, it might work, but you 

know, it is—we are not talking about a small economy here. It is 

very important to get it right. Another thing is that somebody 

brought up the breathalyzer test. I don’t know if the guy who I am 

facing on the road has taken that test when I am driving and he 

is driving at 80 miles; I don’t have that information. So I want 

somebody to test him before he gets in the vehicle, and there are 

certain safeguards if he messes up that he loses his license. I think 

that that is what you need. Also, some people say don’t worry, the 

market is going to sort it out. Well, the reality is that that is fantasy. It is fantasy because S&P and Moody’s rated Enron at investment grade approximately 30 days before it went bankrupt. They 

had similar faults with WorldCom. So the market doesn’t necessarily respond to good information. In fact, S&P and Moody’s operating income has doubled. It has doubled over the past 3 years. 

You hear about it all the time in the economist book, but it doesn’t 

work; full disclosure just simply doesn’t work or else S&P and 

Moody’s revenue and operating income would not have doubled 

27

during the process of these major debacles. So you need some safeguards on the front end of this, and you also need safeguards as 

you go along. 

Mr.FITZPATRICK. It looks like Professor Macey—do you want to 

respond to that? 

Mr.MACEY. Well, I guess I will pay a visit from fantasy land over 

here, in terms of having faith in the markets. First, with respect 

to the point about Enron. Certainly, Mr. Egan is right. This was 

not a poster day for the credit rating agencies. It seems to me the 

question that we need to ask ourselves is not the question, you 

know, will there be errors, and will credit ratings agencies screw 

up under the new regulatory regime, the new statutory regime that 

we are talking about today. The question is will the quality of information in the marketplace be better, not will it be perfect. And 

certainly, I think one thing Mr. Egan and I would agree about is 

that the quality of the information that is out there now is, generated by the credit rating agencies, is not good. It is not good for 

two reasons. Number one, it tends not to be very accurate and, 

number two, the adjustments that are made to credit ratings come 

very slow, and they are—that every financial economist or empirical scholar who has looked at this for the last 30 years has understood that credit ratings systematically lag stock market prices and 

that anybody, for free, can look at stock market prices and get a 

much better view of what is going on at Enron, what is going on 

at WorldCom, what is going on in any of the companies that have 

been so much in the press over the last 3 or 4 years. If we open 

the system up to competition, certainly, there will be errors. Certainly, some of the new firms that emerge in this business will 

make mistakes, but on balance, consumers in this market will have 

a lot more to choose from. They don’t have to rely on one rating. 

They can look at several, and the market will sort out the poor performers and, again, the people who are—make the misjudgment, 

the miscalculation, to rely on the bad ratings that emerge in a new 

competitive environment will bear the costs associated with that, 

which is exactly what ought to happen in a free market economy. 

Mr.STEVENS. Mr. Fitzpatrick, may I add something in response 

to the questions that you had posed, just very briefly? The question 

of 3 years or 7 years is one of these classic conundrums I suspect 

that the committee, the Congress faces all the time. I think of it 

as the prunes issue. Are 3 too few; are 7 too many to get, you 

know, regularity restored? The fact is seven years strikes me as 

fine if you are part of a firm that has been doing this for the past 

7 years, but it might be that you have a wonderful new market 

participant ready to enter, and if they are told well, no, you have 

to do this, theoretically, for 7 years before you can get into the 

business, that has a significant anticompetitive impact. So while, 

you know, this is sort of in the eye of the beholder, I think, some 

proving ground or time period, where you are involved, and can 

demonstrate to potential users that you are serious about this business, that you have been doing it with the kind of rigor and quality, is fine. Three years strikes me as a good choice in that regard. 

Seven years strikes me as not really trying to serve opening up this 

market to the kind of competition which I think has been your purpose and the purpose of other supporters of your legislation. 

28

ChairmanOXLEY. The gentleman yields back. On behalf of the 

members, I want to thank all of you for excellent participation. The 

record that we have continued to build for this legislation I think 

is extraordinary. We have had a diverse group of witnesses over a 

number of months, and this may or may not be the last hearing, 

but it certainly was one of the most productive, and I thank you, 

and I also want to thank the Federal District Court for providing 

this wonderful place for a hearing. This is as close as I am going 

to get to being a Federal judge. 

Mr.FITZPATRICK. I hope it is as close as I get to a Federal judge. 

ChairmanOXLEY. That is right. I would like to sentence a couple 

people right now, but I don’t have it in me. Again, thank you all, 

and the committee is adjourned. 

[Whereupon, at 11:40 a.m., the committee was adjourned.] 

(29)

A P P E N D I X

November 29, 2005

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