Credit Rating Agencies: Alternative Compensation Models for Nationally Recognized Statistical Rating Organizations
Published: 2012-01-18T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Over the past decade, concerns repeatedly have been raised about the accuracy of credit ratings provided by a number of nationally recognized statistical rating organizations (NRSRO). NRSRO critics often point to the conflict of interest created by the industrys predominant compensation model in which issuers of securities pay the rating agencies for their ratings (issuer-pays model). In 2006, Congress established Securities and Exchange Commission (SEC) oversight over NRSROs, and recently enhanced this authority through the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). This act also requires GAO to study alternative means for compensating NRSROs. This report discusses (1) alternative models for compensating NRSROs and (2) SECs actions to implement the acts requirements specific to its oversight of NRSROs. To do this work, GAO leveraged its 2010 report on NRSROs (GAO-10-782), reviewed comment letters submitted to SEC as part of its study of alternative compensation models, proposed and finalized rules issued under the act; and interviewed SEC staff and authors of alternative compensation models .
section_title: What GAO Found
paragraphs: As of January 2012, GAO identified seven alternative models for compensating NRSROs (see table below). These models generally were designed to address the conflict of interest in the issuer-pays model, better align the NRSROs interest with users of ratings, or improve incentives NRSROs have to produce reliable and high-quality ratings. However, the amount of detail currently available for each model varies and none has been implemented. According to some of the authors of the models, there is little incentive to continue developing these models because it appears unlikely they will receive attention from regulators or legislators. For example, these authors noted that SEC had not reached out to them to further discuss these models as part of its ongoing study of alternative compensation models for credit rating agencies.
During debate on the Dodd-Frank Act, a model similar to the random-selection model was proposed through an amendment that would have added a section 15E(w) to the Securities Exchange Act of 1934 (15E(w) model). Although the amendment was not included in the final legislation, section 939F of the Dodd- Frank Act requires SEC to study, among other things, alternative means for compensating NRSROs. It also authorizes SEC to, upon completion of the study, establish by rule a system for assigning NRSROs to determine initial credit ratings and monitor the ratings of structured finance products in a manner that prevents the arranger from selecting the NRSRO that will determine the credit rating should SEC conclude that an alternative system is necessary or appropriate. In issuing any rule, SEC also must give thorough consideration to the section 15E(w) model and implement the model unless it determines that an alternative would better serve the public interest and protect investors. As part of its solicitation of comments for its ongoing study of alternative compensation models, SEC requested that interested parties use the framework GAO developed in the 2010 report on NRSROs to evaluate the section 15E(w) and other models. GAO created this evaluative framework to help identify the relative strengths and weaknesses and potential trade offs (in terms of policy goals) of the models. Based on GAOs analysis of comment letters to SEC, while a number of comment letters generally favored implementing the section 15E(w) model, slightly more opposed the implementation of any of the models. Those supporting the 15E(w) model highlighted the need to address the conflict of interests inherent in the issuer-pays model. Those opposed to the alternative compensation models cited concerns of replacing one set of conflicts of interest with another and the costs of implementation. A number of the letters either supported or made suggestions for improving existing SEC rules. A few comment letters also raised legal questions about the implementation or rulemaking for specific aspects of certain models.
In addition to studying alternative compensation models, SEC has begun to implement a number of Dodd-Frank Act requirements pertaining to NRSROs. These requirements include additional rulemakings related to NRSROs disclosures of performance statistics, credit ratings methodologies, third-party due diligence for asset-backed securities, and analyst training and testing standards. Of nine rulemaking requirements, SEC has adopted three final rules that implement all or part of certain requirements and proposed rules for the remaining requirements. SEC also has been working to establish an Office of Credit Ratings as required by the act. Moreover, SEC examination staff completed the first cycle of annual examinations of each NRSRO as required by the Dodd-Frank Act and published their summary report in September 2011. As part of its study on alternative compensation models for NRSROs, SEC solicited comment on SECs authority to implement various alternative compensation models. According to SEC staff, they are reviewing the comment letters received and evaluating authority issues. Any recommendations for regulatory or statutory changes SEC determines should be made to implement the findings of the study are to be included in their report to Congress, due in July 2012. The model authors opinions of the extent to which statutory changes would be needed to implement their alternative compensation models vary, with one stating that current law provides SEC with the necessary authority and another anticipating the need for legislation. Given that NRSROs continue to primarily use the issuer-pays, and to a lesser extent, the subscriber-pays models, the use of any alternative model or models would likely have to be at the direction of SEC or Congress. However, the extent to which SECs existing authorities would allow it to implement any of the alternative models by rule largely will depend on the alternative model or models selected. Obtaining as complete information on the models as available, such as by consulting with the models authors, will be important for SEC to fully assess each model in order to make its decision and any recommendations for statutory changes SEC determines should be made to implement the findings of its section 939Fstudy.
section_title: What GAO Recommends
paragraphs: SEC should consult with the authors of the proposed models to obtain all available information as it considers the various alternative compensation models and any recommendations for
statutory changes SEC determines should be made to implement the findings of its section 939F study. SEC agreed with the recommendation.

section_title: Letter
paragraphs: As the financial crisis unfolded in 2007 and 2008, questions were raised  about the role that nationally recognized statistical rating organizations  (NRSRO) played in the securitization of high-risk mortgages into  investment grade securities, the accuracy of the credit ratings assigned to  these securities, and the integrity of these NRSROs’ ratings process.  Although ratings downgrades for investment grade securities are  generally infrequent, a report by the Permanent Investigations  Subcommittee of the Senate Homeland Security and Governmental  Affairs Committee notes that by 2010, 90 percent of the residential  mortgage-backed securities issued in 2006 and 2007 that had received  an investment grade rating from the two largest NRSROs were  downgraded to junk bond status. Critics of NRSROs pointed to the  conflict of interest created by the industry’s predominant compensation  model in which issuers of securities pay the rating agencies for their  ratings (issuer-pays model) as a contributing factor to the poor ratings  performance.
Moreover, in the early 2000s, the NRSROs were criticized for failing to  warn investors in a timely manner about the impending bankruptcies of  Enron and other issuers. Consequently, Congress required the Securities  and Exchange Commission (SEC) to study the role and function of credit  rating agencies in the securities markets. In its 2003 report, SEC  identified multiple concerns, such as the concentration of credit rating  agencies, the potential conflict of interest generated by the NRSROs’  issuer-pays compensation model, and the lack of a formal regulatory  program to oversee NRSROs.
Pub. L. No. 109-291, 120 Stat. 1327 (2006) (amending the Securities Exchange Act of  1934 and codified at various sections of Title 15 of the U.S. Code). reduce conflicts of interest and ways to increase NRSRO incentives to  produce accurate ratings.
More recently, the Dodd-Frank Wall Street Reform and Consumer  Protection Act (Dodd-Frank Act) imposed new self-executing  requirements on NRSROs, required SEC to adopt certain rules for  NRSROs, and required SEC to conduct certain studies. SEC must periodically review the implementation of policies that  NRSROs must establish concerning evaluations of possible conflicts of  interest related to former employees. Other requirements relate to  disclosures of performance statistics, credit ratings methodologies, third- party due diligence for asset-backed securities, and analyst training and  testing standards. In addition, section 939F requires SEC to study, among  other things, the credit rating process for structured finance products and  associated conflicts of interest, the feasibility of establishing a system in  which a public or private utility or a self-regulatory organization assigns  NRSROs to determine the credit ratings of structured finance products,  and alternative means for compensating NRSROs that would create  incentives for accurate credit ratings (hereafter referred to as the 939F  study). Section 939F requires SEC to submit to Congress the findings of  the study and any recommendations for regulatory or statutory changes  SEC determines should be made to implement the findings by July 21,  2012.
Pub. L. No. 111-203, §§ 931-939H, 872 Stat 1376, 1872-1890 (2010). In addition to  provisions related to oversight, the Dodd-Frank Act requires every federal agency to  review regulations that require assessments of the creditworthiness of a security or money  market instrument and any references to credit ratings in such regulations; to modify such  regulations to remove any reference to, or requirement for, reliance on credit ratings; and  substitute a standard of creditworthiness an agency deems appropriate. 15 U.S.C. § 78o-7  note. statutory changes that would facilitate the use of such an alternative  model. In response to this mandate, this report discusses (1) alternative  compensation models for NRSROs and (2) the actions SEC has taken to  implement the Dodd-Frank Act requirements specific to SEC’s oversight  of NRSROs and SEC’s authority to implement an alternative  compensation model under current securities laws.
To identify alternative compensation models, we conducted a literature  search to identify academic, industry papers, or journal articles and we  reviewed past GAO reports, notably our 2010 report that examined  alternative compensation models, among other things. the comment letters submitted to SEC for the 939F study. We reviewed  these letters to identify market participants’ views on the implementation  of an alternative compensation model and, where possible, the perceived  advantages and disadvantages of the models. In addition, we interviewed  SEC staff and the authors of the compensation models discussed in our  2010 report to identify any new models and obtain information on any  additional work they have completed on the previously identified models.  We also solicited and obtained comments from the authors of the two  models we identified since we issued the 2010 report. To identify the  actions SEC has taken to implement various Dodd-Frank Act  requirements, we reviewed SEC proposed and final rules issued pursuant  to the act and interviewed SEC staff to identify prior and current  regulatory actions that SEC has taken and challenges it has faced in  implementing the requirements. To review SEC’s authority to implement  alternative compensation models and statutory changes that would  facilitate the use of an alternative means of compensation, we interviewed  SEC staff and attorneys, reviewed the comment letters submitted to SEC  for its 939F study, reviewed relevant statutory authority, and solicited  comments from the authors of the compensation models, which included  two law professors, an economist, and market participants.
GAO-10-782. evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: A credit rating is an assessment of the creditworthiness of an obligor as  an entity or in relation to specific securities or money market instruments.  SEC first used the term “Nationally Recognized Statistical Rating  Organization” in 1975 to describe those rating agencies whose ratings  could be relied upon to determine capital charges for different types of  debt securities (securities) broker-dealers held. Since then, SEC has  used the NRSRO designation in a number of regulations, and the term  has been embedded in numerous federal and state laws and regulations,  investment guidelines, and private contracts. As will be discussed, SEC  has issued a series of proposals regarding the removal of references to  credit ratings in its regulations in accordance with the Dodd-Frank Act.
NRSRO credit ratings are intended to measure the likelihood of default for  an issue or issuer, although some also measure variables such as the  expected value of dollar losses given a default. The NRSROs describe  ratings as being intended only to reflect credit risk, not other valuation  factors such as liquidity or price risk. To determine an appropriate rating,  analysts at rating agencies use publicly available information and market  and economic data, and may hold discussions and obtain nonpublic  information from the issuer.
Issuers seek credit ratings for reasons such as improving the  marketability or pricing of their securities or satisfying investors, lenders,  or counterparties. Institutional investors, such as mutual funds, pension  funds, and insurance companies, are among the largest owners of debt  securities in the United States and are substantial users of credit ratings.  Institutional investors may use credit ratings as one of several inputs to  their internal credit assessments and investment analyses, or to identify  pricing discrepancies for their trading operations. Broker-dealers also use  ratings to recommend and sell securities to their clients or determine  acceptable counterparties, and collateral levels for outstanding credit  exposures.
CRARA established SEC oversight of credit rating agencies registered as  NRSROs. Specifically, CRARA added section 15E to the Securities  Exchange Act of 1934 to provide SEC with examination authority and  establish a registration program for credit rating agencies seeking  NRSRO designation. SEC adopted final rules for a formal registration and  oversight program for NRSROs in June 2007. SEC amended several of  these rules in February and December 2009 with the goal of further  increasing transparency of NRSRO rating methodologies, strengthening  the disclosures of ratings performance, prohibiting NRSROs from  engaging in certain practices, and enhancing NRSRO record keeping.
Since the implementation of CRARA, SEC has registered 10 credit rating  agencies as NRSROs. One of these credit rating agencies has recently  withdrawn from registration as an NRSRO.pays compensation model and three operate primarily under the  subscriber-pays compensation model, in which users pay a subscription  fee to the NRSRO for access to its ratings. Despite the growth in the  number of NRSROs and the availability of credit ratings from NRSROs  operating under a subscriber-pays model, the market remains highly  concentrated. In 2011, SEC reported that the three largest NRSROs  (Standard & Poor’s, Moody’s Investment Services, and Fitch Ratings)  issued approximately 97 percent of all outstanding ratings. Furthermore,  NRSROs operating under the issuer-pays model issued approximately 99  percent of the total currently outstanding NRSRO credit ratings.  Economists note that the credit rating industry has exhibited a high level  of concentration throughout much of its history. SEC and others have  noted that the regulatory use of ratings, economies of scale, high fixed  costs, and network effects (the value or utility of products or services  increasing with the number of users) as factors that have created barriers  to entry and led to concentration in the credit rating industry.
section_title: New Developments on Alternative Compensation Models Are Limited
paragraphs: In our 2010 report, we identified five proposed models—random  selection, investor-owned credit rating agency, stand-alone, designation,  user-pays—and summarized key features of these proposed models.
When we conducted our 2010 study, the level of development for each  model varied and none had been implemented. Our current study  identified two additional proposed models—the alternative user-pays  model and the issuer and investor-pays model—and found that little  additional work had been completed on the previously identified models  that would provide further details about how each would function.  According to some of the authors of these models, there is little incentive  to continue developing these models, as the issue of alternative  compensation models for NRSROs and their possible implementation  appears unlikely to receive much, if any, attention from regulators or  legislators. For example, these authors told us that SEC had not reached  out to them to further discuss these models as part of the 939F  study. However, SEC did solicit public comments about the models  through a public notice in conducting its 939F study. Furthermore, SEC  staff said that they held follow-up discussions with the authors of some of  the models after the 2009 SEC roundtable. While these models  generally are intended to address the conflict of interest in the issuer-pays  model, some comment letters to SEC for its section 939F study described  a number of perceived disadvantages of these models. None of the  models has been implemented as of January 2012.
section_title: Proposed Alternative Compensation Models
paragraphs: As of January 2012, we have identified seven proposed alternative  compensation models. The following summarizes the key features of  each of these proposed models.
A ratings clearinghouse randomly would select NRSROs to rate a new  issuance in this proposed model. The clearinghouse could be a nonprofit,  a governmental agency such as SEC, or a private-public partnership that  would design the criteria by which new entrants could qualify as a credit  rating agency. All issuers or sponsors that wanted ratings for their  issuances would request them from the clearinghouse, which would use a  random number generator to assign an NRSRO registered in the relevant  asset class to produce the rating. The clearinghouse would notify the  NRSRO of the opportunity to rate the issuance and provide basic  information on the type of issuance but not the issuer’s name. Not until  the NRSRO agreed to complete the rating would the clearinghouse  identify the issuer and details of the issuance. If the selected NRSRO  agreed to rate the issuance, the issuer would pay a fee to the  clearinghouse. The issuer also would pay to cover clearinghouse costs on  top of those required to rate the security. Upon completion of the initial  and maintenance ratings, the clearinghouse would distribute the fees to  the NRSRO. The clearinghouse would set the ratings fees for the NRSRO  depending on the type of security issued, but the letter rating would be  free of charge to the public.
The proposed model incorporates a peer comparison review to create an  incentive for NRSROs to produce quality ratings. As part of this review,  the clearinghouse would evaluate the performance of all NRSROs on the  basis of two empirical tests. For instance, if the default percentage of debt  instruments rated by a given NRSRO differed from the default percentage  of its peers by a set parameter, then the NRSRO would be subject to  sanctions such as losing a percentage of business or rating fees. A  second test would compare annual yields of identically rated debt  securities from different asset classes. Securities in different asset  classes that are rated similarly should have the same yield. An NRSRO  would be subject to sanctions if the yields of identically rated securities  differed by a certain threshold.
According to the author of this proposed model, by eliminating the linkage  between the NRSRO and the issuer, this model would eliminate the  conflict of interest stemming from the issuer-pays model. Furthermore,  the author stated that the peer comparison review coupled with economic  sanctions for poor performance would motivate the NRSROs to  continually adjust their models and produce quality ratings.
Under this model, sophisticated investors—referred to as “highly  sophisticated institutional purchasers” in the model—would create and  operate an NRSRO that would produce ratings. Issuers would have to  obtain two ratings—one from the investor-owned NRSRO and the second  from their choice of NRSRO. More specifically, an NRSRO could not  publicly release a rating for which an issuer or sponsor paid unless the  NRSRO received written notification that the issuer had paid an investor- owned NRSRO to publicly release its rating. The investor-owned NRSRO  would publish its rating on or before the date on which the solicited  NRSRO published its rating.
Institutional investors would have to qualify as highly sophisticated  institutional purchasers before forming or joining an investor-owned  agency. To qualify, an institutional investor would have to demonstrate  that it was large and sophisticated, managed billions of dollars in assets,  and could be relied upon to represent the buy-side interest in accurately  rating debt market instruments. The investor-purchasers would hold  majority voting and operational control over the agency, which could be  for-profit or not-for-profit. Market forces would set the agency fees, which  likely would be comparable to fees currently charged by dominant  NRSROs. The letter rating and the underlying research would be free to  the public.
Proponents of this model believe that it would improve the rating process  by changing incentive structures. They said that investor-owned agencies  would introduce new competition to the industry and balance the  investors’ interests against issuers’ interests.
NRSROs would only be permitted to produce credit ratings in this  proposed model. They could interact with and advise organizations being  rated, but could not charge fees for advice. Instead of receiving issuer  fees, the NRSROs would be compensated through transaction fees for  original issuance and secondary market transactions. The issuer or  secondary-market seller would pay part of the fee, and the investor  purchasing the security (in the primary or secondary market) would pay  the other part. The NRSRO would be compensated over the life of the  security based on these transaction fees. The letter rating would be free  to the public.
Proponents of this model believe that by creating a funding source  beyond the influence of both issuers and investors, NRSROs would focus  on producing the most accurate and timely credit analysis rather than on  satisfying the desires of any other vested interest.
In this proposed model, all NRSROs could opt to rate a new issuance and  security holders would direct, or designate, fees to the NRSROs of their  choice. When an issuer brought a security to market, it would have to  provide all interested NRSROs with the information to rate the issuance  and pay rating fees to a third-party administrator, which would manage  the designation process. The investors that purchased the debt  issuance would each designate one or several NRSROs that rated the  security to receive fees, based on their perception of research underlying  the ratings. The third-party administrator would disburse the fees in  accordance with the designations. After the initial rating, the issuer  would continue to pay maintenance rating fees to the third-party  administrator. A final rating fee would be paid in conjunction with the  retirement (or repurchase) of the security. The letter rating would be free  to the public, while the research underlying it would be distributed to  security holders and (at the discretion of the relevant NRSROs) to  potential security holders.
The authors of this proposed model said it would eliminate conflicts of  interest resulting from issuers paying for ratings and increase competition  by allowing all NRSROs access to the information necessary to rate any  issuance. The authors also stated that this model encourages NRSROs  to prepare ratings because each NRSRO that did could profit from its  ratings to the extent investors or other users find the ratings useful.
Issuers would not pay for ratings under this proposed model; rather, all  users of ratings would enter into a contract with an NRSRO and pay for  rating services. The proposal defines “user” as any entity that included a  rated security, loan, or contract as an element of its assets or liabilities as  recorded in an audited financial statement. For example, users could be  holders of long or short positions in a fixed-income instrument, parties  that refer to a credit rating in contractual commitments (that is, as parties  to a lease), or parties to derivative products that rely on rated securities or  entities. A user would have to pay for ratings services supplied during  each period in which it booked the related asset or liability.
The proposed model relies on third-party auditors to ensure that NRSROs  receive payment for their services from users of ratings. The user would  have to demonstrate to the auditors that the holder of a rated instrument  or contract paid for the rating services. Until auditors were satisfied that  NRSROs had been properly compensated, they would not issue audit  opinions. The model would require the close cooperation of the auditing  community and the Public Company Auditing Oversight Board.
The authors of this model stated that, while more cumbersome, the model  attempts to capture “free riders”—those users of ratings that do not  compensate NRSROs for the use of their intellectual property—and  requires them to pay for ratings.
The alternative user-pays model would pool creditors’ resources to  secure ratings before debt was issued. A government agency or  independent board would administer a user-fee system financed by debt  purchasers, which would fund a competitive bidding process for the  selection of rating agencies. The agency or board would solicit ratings  before the debt issuance and then pay for the expense and related  administrative costs through the user fee. The user fee could be  assessed through a flat fraction of a percentage fee on the initial  purchasers of debt offerings. The user fee would allow the agency or  board to finance initial ratings on a rolling basis, with the ratings for a  given debt issuance being secured before the issuance of the debt.  Although the fee could be assessed in many ways, the author of the  model suggests a one-time fee at initial sale for administrative ease.
NRSROs would bid on the right to issue ratings with the agency or board  determining how best to judge the bids and award the right to rate the  issuance. For example, the agency or board could weigh factors such as  price, extent of diligence the NRSRO proposed to undertake, and the  disclosures the NRSRO would demand from issuers as a condition for the  rating. The author believes the bidding process would serve to contain the  costs for ratings through price competition, level the playing field for  smaller competitors and new entrants, and balance the desire for market- based assessments of risk with a greater role for the government agency,  such as SEC, or an independent board in defining rating agencies’  responsibilities.
According to its author, this user-fee model creates additional  accountability mechanisms. Users of ratings would be given enforceable  rights and would require NRSROs to assume certification and mandatory  reporting duties to creditors. The system would set up creditor  committees that would serve as a channel for creditors to monitor ratings  and assert limited rights against NRSROs. If an NRSRO breached duties  owed to the creditors, the committee would serve as the representative in  any potential actions and preempt actions brought by individual creditors.  The model would require that all contracts with NRSROs detail duties  owed to their creditors, to delineate the potential liability exposure for  breach of these duties, and channel adjudication of any disputes to an  SEC administrative process. For example, NRSROs could be required to  certify on a quarterly basis that they exercised reasonable care in  conducting due diligence of issuers’ financial and nonfinancial disclosures  to make accurate assessments of risk exposure. To provide NRSROs  with incentives for compliance without jeopardizing their financial viability,  the model would limit NRSRO financial liability to cases of gross  negligence, coupled with an earnings-based cap on liability and other  safeguards.
This proposed model incorporates characteristics from a number of the  models described earlier and leverages an existing structure as the basis  for collecting and distributing ratings fees. Under the proposed issuer and  investor-pays model, accredited NRSROs would be assigned to rate new  issuances. Initially, all NRSROs would be placed in a continuous queue  and would receive rating assignments when their respective numbers  came up, unless they were unable or unwilling to rate a particular issue.  In the future, ratings would be assigned based on the performances of the  NRSROs, with those agencies that produced superior performance  receiving more assignments. Performance would be measured as the  correlation between an NRSRO’s ratings and default and recovery rates  on issues rated, and tracked using a common, transparent, and  defensible methodology. To help ensure rigor and fairness, at least two  and possibly three NRSROs would be assigned to rate each issuance.
Payments for ratings would come from a fee levied on issuers of new  debt issues and investors as parties of secondary market trades. These  fees would be deposited in a dedicated fund—the U.S. Ratings Fund— and would be determined and reset periodically. The periodic review  would consider the historic and projected volumes of primary issuances  and of secondary market trading to determine a fee that would in the  aggregate allow the ratings business to attract and retain qualified  individuals. This fund would be modeled after the Municipal Securities  Rulemaking Board (MSRB), which is authorized to collect fees on new  and secondary market municipal issues to fund its activities, and would  be overseen by a governing board representing issuers, investors, rating  agencies, intermediaries, and independent directors. The fees collected  would be used to pay the selected accredited NRSROs for issuing each  solicited rating and other necessary administrative activities such as  tracking NRSRO’s performance and tracking deals to be rated. The  authors note that these other activities could be outsourced or performed  by the U.S. Ratings Fund. The Fund also would advise SEC on the  eligibility and accreditation of the NRSROs. All ratings and related  research reports paid for through the U.S. Ratings Fund would be freely  available to the public.
According to the authors, NRSROs would have incentives to provide  accurate ratings and be objective because ratings would be monitored by  a regulator and the accreditation of NRSROs would be subject to periodic  renewal. The authors also note that legislation likely would be required to  set up the new rating agency compensation model. Specifically, the  authors said that legislation would need to enumerate the functions and  the governance structure of the U.S. Ratings Fund, provide its mandate  and methodology for determining the fees to be charged for ratings, and  elaborate on how the new rating model would be introduced.
subsections: section_title: Comment Letters to SEC Supported Implementing One Alternative Model or Enhancing Existing Rules
paragraphs: During debate on the Dodd-Frank Act, a system similar to the random  selection model was proposed through an amendment to the Securities  Exchange Act of 1934. Proposed section 939D would have added a  section 15E(w) to the Exchange Act which would require SEC to establish  a Credit Rating Agency Board that was a self-regulatory organization  subject to SEC’s oversight. The Board would determine NRSROs that are  eligible to issue initial credit ratings for structured finance products and  assign NRSROs to rate the issuances (NRSROs could decline). The  method for selecting the qualified NRSROs would be based on a Board  evaluation of alternatives designed to reduce the conflicts of interest  under the issuer-pays model, including a lottery or rotational assignment  system. Although the section 939D amendment was passed by the  Senate, it was not included in the final legislation. However, the Dodd- Frank Act provides that upon completion of the section 939F study, SEC  shall, as it determines is necessary or appropriate in the public interest or  for the protection of investors, establish by rule a system for the  assignment of NRSROs to determine the initial credit ratings and monitor  the credit ratings of structured finance products in a manner that prevents  the arranger from selecting the NRSRO that will determine the credit  rating. In issuing any rule, the act requires SEC to give thorough  consideration to the provisions of section 15E(w) of the Exchange Act, as  that provision would have been added by section 939D as passed by the  Senate on May 20, 2010, and SEC must implement the system described  in such section 939D unless SEC determines that an alternative system  would better serve the public interest and the protection of investors.
In May 2011, SEC requested that interested parties provide comments on  whether any potential alternative compensation model, including four of  the models we described in our 2010 report and discussed previously  would provide a reasonable alternative to the section 15E(w) model in  terms of objectives and goals. SEC omitted the random selection model  from its request for comment because it is similar to the section 15E(w)  model. As part of this solicitation of comments, SEC requested that  interested parties use the evaluative framework we developed for our  2010 report to evaluate the section 15E(w) and other alternative  compensation models. The comment period ended in September 2011.
Our analysis of the comment letters that various market participants and  observers submitted on SEC’s section 939F study found that while some  supported implementing the section 15E(w) model, others preferred  enhancing existing SEC rules. Of the 30 comment letters submitted, our  assessments found that 11 generally favored implementing an alternative  compensation model, 13 opposed the implementation of an alternative  compensation model, and 5 did not comment on the need for an  alternative compensation model. Sixteen comment letters either  supported or made suggestions for improving existing SEC rules. None of  the comment letters supported any of the other alternative compensation  models described by SEC in its request for comment.addressed the alternative models individually and all were critical of these  alternatives.
Only the section 15E(w) model received specific support from those that  supported the implementation of an alternative compensation model.  Generally, these letters highlighted the need to address the conflict of  interest inherent in the issuer-pays model. For example, one commenter  stated that an assignment system—such as the one proposed in the  model—best serves the public interest by increasing competition to allow  for new NRSRO participants. The author of another comment letter stated  that on balance he favored a system—such as the one proposed in the  15E(w) model—that would separate issuer payment for ratings on  structured finance products from issuer selection of NRSROs.
Those opposed to the implementation of an alternative compensation  model, including the section 15E(w) model, cited concerns such as  replacing one set of conflicts of interest with another and raised issues  about the cost of implementation. According to a few comment letters,  each of the proposed models presents its own unique set of issues and  often substitutes one type of conflict of interest for another. For example,  one comment letter stated that each compensation model has  unavoidable conflicts of interest and that none of the alternatives  presented by SEC would offer practical or effective solutions to the risks  of potential conflicts engendered by the issuer-pays model. Another  comment letter cited specific conflicts various market participants may  have, concluding that changing “who pays” the credit rating agency will  not eliminate the potential for conflicts: it will only shift the conflicts from  one set of interested parties to another. Comment letters also stated  that some of the models would create large costs. For example, one  comment letter stated that the selection board created in the section  15E(w) model would need to employ a significant staff with highly  specialized skills to credibly carry out its responsibilities. Another letter  described the extensive amount of infrastructure that would be needed to  assess fees on each trade, such as those required by the stand-alone  model.
Rule 17g-5 requires an NRSRO hired to determine initial credit ratings for structured  finance products to maintain a password-protected Internet website containing a list of  each such structured finance product for which it currently is in the process of determining  an initial credit rating. The rule is designed to make it more difficult for arrangers to exert  influence over the NRSRO they hire because any inappropriate rating could be exposed to  the market through the unsolicited ratings issued by NRSROs not hired to rate the  structured finance product. However, the rule limits the number of times an NRSRO can  access the information without having to produce its own credit ratings. An NRSRO that  accesses information 10 or more times during the calendar year must produce a credit  rating for at least 10 percent of the issues for which it accessed information. See 17  C.F.R. § 240.17g-5(a)(3). information provided to the selected NRSRO to be made more broadly  available, particularly to investors.
section_title: SEC Is Implementing the Dodd-Frank Act and Reviewing Its Authority to Implement the Alternative Compensation Models
paragraphs: The Dodd-Frank Act requires SEC to take a number of actions regarding  its oversight of NRSROs including issuing a number of rulemakings,  establishing an Office of Credit Ratings, and studying, among other  things, the feasibility of an assignment system for the ratings of structured  finance products and alternative means for compensating NRSROs. As  part of this study, SEC has solicited comment on its authority to  implement the alternative compensation models.
subsections: section_title: SEC Has Taken a Number of Steps to Implement Dodd-Frank Act Requirements
paragraphs: Since the enactment of the Dodd-Frank Act in July 2010, SEC has taken  a number of steps to implement the parts of the act pertaining to  NRSROs. Of the 15 requirements for SEC contained in Title IX of the  Dodd-Frank Act, 9 require SEC to issue rules. As of January 2012, SEC  has adopted three final rules that implement all or part of certain  requirements and proposed rules to implement the remaining  requirements. Specifically, SEC has adopted rules removing the  exemption for NRSROs from the Fair Disclosure Rule; requiring NRSROs  to include a report accompanying a credit rating for an asset-backed  security describing representations, warranties, and enforcement  mechanisms available to investors; and removing references to NRSRO  credit ratings from certain securities registration requirements. SEC has  also proposed a number of amendments to existing rules or new rules to  implement the remainder of the Dodd-Frank Act requirements applicable  to NRSROs. Table 1 provides a summary of these proposals.
In addition to its work on NRSRO oversight rules, SEC continues to work  on other Dodd-Frank Act requirements related to NRSROs. These  requirements include completing four studies on various aspects of the  credit rating industry. As of January 2012, SEC has completed one of  the four studies and issued a report which provided a summary of SEC  regulations requiring the use of an assessment of the creditworthiness of  a security or money market instrument and any references to or  requirements in such regulations regarding credit ratings. According to  SEC’s website, SEC plans to complete two of the remaining three studies  by July 2012; the completion date for the other study has yet to be  determined.
Finally, the Dodd-Frank Act requires SEC to establish an Office of Credit  Ratings and complete annual examinations of each NRSRO. Once  established, this office will be responsible for administering the rules of  SEC in certain areas, promoting accuracy in credit ratings, and  conducting annual examinations of each NRSRO. Although the office  has yet to be established, NRSRO examination staff from SEC’s Office of  Compliance Inspections and Examinations (OCIE), staff from OCIE’s  investment adviser/investment company and broker-dealer examination  groups, and NRSRO specialists from SEC’s Division of Trading and  Markets recently completed the first cycle of annual examinations of each  NRSRO as required by the Dodd-Frank Act. SEC made public a staff  report summarizing the examinations in September 2011. According to  this report, limited SEC resources required that this year’s examinations  focus on reviewing the areas mandated by section 15E(p)(3)(B)— specifically, whether the NRSRO conducts business in accordance with  its policies, procedures, and rating methodologies; management of  conflicts of interest; implementation of ethics policies; internal supervisory  controls; governance; activities of the designated compliance officer;  processing of complaints; and NRSRO’s policies governing the post- employment activities of former staff of the NRSRO. The report  summarized the examination staff’s notable observations and concerns  and the recommendations the staff made to each NRSRO about these  observations and concerns related to the following required review areas:  conducting business in accordance with policies, procedures, and  methodologies; management of conflicts of interest; internal supervisory  controls; and designated compliance officer activities. The report notes  that, as of the date of the report, SEC had not determined that any finding  constituted a “material regulatory deficiency,” but noted that the  Commission may do so in the future. The staff also made the observation  that NRSROs appear to be trending even more toward employing the  issuer-pays business model, noting that two of the subscriber-pays  NRSROs recently have taken steps to focus more on issuer-pays  business, particularly with respect to ratings of asset-back securities.
section_title: SEC Is Conducting Its Required Study of Alternative Compensation Models, but Has Yet to Talk to the Models’ Authors
paragraphs: Section 939F of the Dodd-Frank Act requires that SEC conduct a study  that addresses, among other things, the feasibility of establishing a  system in which a public or private utility or an SRO assigns NRSROs to  determine the credit ratings of structured finance products. SEC’s report  on the study, due by July 21, 2012, must include any recommendations  for regulatory or statutory changes that SEC determines should be made  to implement the findings of the study. As part of this study, SEC solicited  comment on its authority to implement various alternative compensation  models. According to SEC staff, the staff is reviewing the comment letters  received and is evaluating authority issues.
Section 939F requires that, after submission of the report to Congress  resulting from the study, SEC shall, by rule, as the SEC determines is  necessary or appropriate in the public interest or for the protection of  investors, establish a system for the assignment of NRSROs to determine  the initial credit ratings of structured finance products, in a manner that  prevents the issuer, sponsor, or underwriter of the structured finance  product from selecting the NRSRO that will determine the initial credit  ratings and monitor such credit ratings. In issuing any rule, SEC is  required to give through consideration to the provisions of section 15E(w)  of the Securities Exchange Act of 1934, as that provision would have  been added by section 939D of H.R. 4173 (111th Congress), as passed by  the Senate on May 20, 2010, and shall implement the system described  in such section 939D unless the Commission determines that an  alternative system would better serve the public interest and the  protection of investors. The need for any statutory changes likely will  depend on the system that SEC decides to implement. Therefore,  obtaining as complete information on the models as available, such as by  consulting with the models’ authors, will be important for SEC to fully  assess each model in order to make its decision and any  recommendations for statutory changes SEC determines should be made  to implement its findings.
As part of its request for public comment in connection with its study, SEC  requested comment on whether the securities laws provide SEC with  authority to implement the 15E(w) system and the four other models it  outlined. In particular, SEC asked for comment on whether, in terms of  legal feasibility, the role of SEC in overseeing the Credit Rating Agency  Board raised legal issues. Few comment letters directly addressed SEC’s  questions concerning its authority to implement one or any of the  alternative compensation models outlined in its request for comment.  However, a few of the comment letters discussed potential legal  questions surrounding the implementation of or rulemaking for specific  aspects of certain models, or general constitutional questions. For  instance, two commenters argued that in their view, NRSRO ratings  legally are viewed as opinions and may not be subject to being proven  true or false. Thus any system that utilizes the accuracy of ratings as  criteria to determine which NRSROs would be eligible to rate certain  categories of securities—such as the 15E(w) system—may face legal  challenges. One comment letter also argued that any system aimed at  defining “quality” ratings could run afoul of Section 15E(c)(2) of the  Exchange Act, which provides that SEC may not “regulate the substance  of credit ratings or the procedures and methodologies by which any  NRSRO determines credit ratings.” The letter states that any decision  by SEC that an NRSRO’s ratings (and, by extension, the criteria and  methodologies by which those ratings were formed) lack “quality” and  therefore must be changed to maintain participation in the proposed  system could well violate this provision. In addition, three comment letters  raised constitutional questions. Two comment letters questioned how  certain of the alternative models might affect an NRSRO’s right to form  and publish opinions under the First Amendment. Another questioned the  ability of the government to force one private party to deal with another  private party of the government’s choosing in a private business  transaction, which the commenter argues would occur if SEC  implemented the section 15E(w) model.
The model authors also hold varying opinions on the extent to which  statutory changes would be necessary to implement their alternative  compensation model. For example, in their paper introducing the model  and in our discussions with them, the authors of the proposed issuer and  investor-pays model discussed that they anticipate that legislation would  likely be required to implement their proposed model. Specifically, authors  of the model stated that legislation would likely be necessary to establish  the self-regulatory organization and provide it with the authority to create  a fund to collect fees and impose data collection requirements on  issuances, the governance structure of the fund, the methodology for  determining fees, an initial rotating system of assignments of issues to be  rated, and broad parameters for incentive compensation. Alternatively,  the author of the proposed investor-owned credit rating agency model we  interviewed believes that current law, even before the Dodd-Frank Act  was passed, provides SEC with the authority to implement the model as a  means of managing the conflicts of interest generated by the issuer-pays  model. Specifically, the author points to sections 15E(h)(2) of the  Exchange Act, which grants SEC the authority to issue rules to prohibit,  or require the management and disclosure of, any conflicts of interest  relating to the issuance of credit ratings by the NRSRO. This includes  the authority to issue rules relating to the manner in which an NRSRO is  compensated by the issuer for issuing credit ratings. The author also  stated that section 15E(i)(1), which provides that SEC shall issue rules to  prohibit any act or practice relating to the issuance of credit ratings by an  NRSRO that SEC determines to be unfair, coercive, or abusive provides  additional statutory authority for the implementation of the investor-owned  credit rating agency model. As previously discussed, SEC has not  spoken to the authors of the proposed models to solicit additional details  about their models—information that could help inform SEC’s analysis of  the alternative compensation models and its report to Congress  containing any recommendations for regulatory or statutory changes that  it determines should be made to implement the findings of its study.
section_title: Conclusion
paragraphs: In recent years, academic researchers and industry experts have begun  to develop a number of alternative compensation models for credit rating  agencies in response to concerns about conflict of interest, ratings  integrity, and competition. As of January 2012, none of these models  have been fully developed, and given that NRSROs continue to primarily  use the issuer-pays, and to a lesser extent, the subscriber-pays models,  the use of any alternative model or models would likely have to be at the  direction of SEC or Congress. As directed by section 939F of the Dodd- Frank Act, SEC is currently studying, among other things, alternative  means for compensating NRSROs that would create incentives for  accurate credit ratings. As part of its study, SEC solicited public comment  on various alternative compensation models and whether it has sufficient  authority to implement these models.  Few of the comment letters SEC  received specifically addressed the alternative models or SEC’s authority  to implement them, and only one of the model authors submitted a  comment letter to SEC. Currently, the staff is reviewing the comment  letters received and evaluating authority issues, however the extent to  which SEC’s existing authorities would allow it to implement any of the  alternative models by rule largely will depend on the system selected. As  part of its 939F study, SEC has not met with the authors of the various  alternative compensation models to discuss the models in greater detail.  Doing so could help ensure that SEC has thoroughly explored all of the  available options in sufficient enough detail to adequately consider them.  Without consulting the authors to gain a comprehensive understanding of  the proposed models, SEC may not have complete information available  to be able to fully determine the authorities it may need to implement a  particular model.
section_title: Recommendation for Executive Action
paragraphs: As SEC continues to study the various alternative means for  compensating NRSROs, as well as determine whether a system for the  assignment of initial credit ratings for structured finance products is  necessary or appropriate in the public interest or for the protection of  investors, SEC should consult with the authors to better ensure it has all  available information on the models to make its decision, and include in  its report to Congress any recommendations for statutory changes the  SEC determines should be made to implement the findings of the study.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of the report to the Chairman of the Securities and  Exchange Commission (SEC) for her review and comment. SEC’s written  comments are reprinted in appendix II. We also received technical  comments from SEC that were incorporated, where appropriate. In its  written comments, SEC agreed with our recommendation. In describing  its statutory responsibilities and the steps it has taken to implement them,  SEC noted that as it continues working on its 939F study, the  Commission staff will seek to consult further with the parties that have  proposed alternative compensation models for NRSROs to better ensure  that the Commission has all available information on such models.
We are sending copies of this report to SEC, appropriate congressional  committees and members, and other interested parties. The report also is  available at no charge on the GAO website at http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  me at (202) 512-8678 or clowersa@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made major contributions to  this report are listed in appendix III.
section_title: Appendix I: Framework to Evaluate Alternative Compensation Models
paragraphs: To assist Congress and others in assessing these proposed alternative  compensation models, we developed an evaluative framework for our  2010 report with seven factors that any compensation model should  address to be fully effective. The framework can help identify a model’s  relative strengths and weaknesses, potential trade-offs (in terms of policy  goals), or areas in which further elaboration or clarification would be  warranted using the following factors:  Independence. The ability for the compensation model to mitigate  conflicts of interest inherent between the entity paying for the rating  and the nationally recognized statistical rating organization (NRSRO).
Accountability. The ability of the compensation model to promote  NRSROs’ responsibility for the accuracy and timeliness of their  ratings.
Competition. The extent to which the compensation model creates  an environment in which NRSROs compete for customers by  producing higher-quality ratings at competitive prices.
Transparency. The accessibility, usability, and clarity of the  compensation model and the dissemination of information on the  model to market participants.
Feasibility. The ease and simplicity with which the compensation  model can be implemented in the securities market.
Market acceptance and choice. The willingness of the securities  market to accept the compensation model, the ratings produced under  that model, and any new market players established by the  compensation model.
Oversight. The evaluation of the model to help ensure it works as  intended.
See GAO-10-782 for more detailed descriptions of the seven factors.
section_title: Appendix II: Comments from the Securities and Exchange Commission
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Karen Tremba (Assistant  Director), Rachel DeMarcus, Patrick Dynes, Matthew Keeler, Patricia  Moye, Barbara Roesmann, and Jessica Sandler made key contributions  to this report.