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

Letter

Background

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.

New Developments on Alternative Compensation Models Are Limited

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.

Proposed Alternative Compensation Models

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.

Comment Letters to SEC Supported Implementing One Alternative Model or Enhancing Existing Rules

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.

SEC Is Implementing the Dodd-Frank Act and Reviewing Its Authority to Implement the Alternative Compensation Models

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.

SEC Has Taken a Number of Steps to Implement Dodd-Frank Act Requirements

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.

SEC Is Conducting Its Required Study of Alternative Compensation Models, but Has Yet to Talk to the Models’ Authors

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.

Conclusion

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.

Recommendation for Executive Action

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.

Agency Comments and Our Evaluation

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.

Appendix I: Framework to Evaluate Alternative Compensation Models

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.

Appendix II: Comments from the Securities and Exchange Commission

Appendix III: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

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.