Origin of the NRSRO designation

At their inception, the Big Three had each adopted an investor-pays business model.

The 1920s was a time when there was increased demand for credit ratings and the investor-pays model prevailed mainly due to the ability of the publishers to exercise physical control over the distribution of their published ratings. The stock market crash of 1929 brought the still fledgling CRA industry to a screeching halt as bonds, including some previously highly rated bonds, defaulted across the board, leaving investors heavily disappointed and questioning the usefulness as well as the reliability of credit ratings. Not surprisingly, investors, en masse, turned their back on the ratings industry.

Although CRAs survived this particular downturn, they continued pretty much unnoticed for the following forty-five years when they received an unexpected boon, courtesy of the Securities and Exchange Commission (SEC). In 1975 S&P, Moody’s and Fitch became the first three recipients of the NRSRO designation when it was bestowed upon them by the SEC’s Division of Market Regulation (DMR). In essence this meant that the three firms were each provided a ‘No Action Relief’⁴⁰ letter which served to notify broker-dealers of their status as NRSROs. ⁴¹ After extensive lobbying efforts, the firms

40 a.k.a. No-action letter.

41 See, Martha Coakley, Rating Agency Consents and Regulation AB, (“Legally, no-action letters are expressions of enforcement policy”.), at 2 (2011) (letter from Massachusetts Att’y Gen. Martha Coakley to the Mary Schapiro, SEC Chairman). Id. “… [The NAL is a] statement of staff enforcement intent”, at 6;

and “…[N]ot intended to affect the rights of private parties”, at 9(citing Thomas P. Lemke, The SEC No-Action Letters Process, 42BUS.LAW 1019, 1042-43 (1987)).

Duff & Phelps Inc., Thomson BankWatch Inc., and IBCA Ltd and IBCA were eventually also designated NRSROs; albeit almost three decades later.

The creation of the NRSRO status was deemed a necessary requirement for adherence to the Net Capital Rule.⁴² The SEC, under rule 15c3-1 of the Net Capital Rule, allowed for preferential treatment in the form of “reduced haircuts” for broker-dealers’

proprietary positions in “commercial paper, nonconvertible debt securities and non-convertible preferred stock in instances where the instruments [we]re rated investment grade by at least two NRSROs”.⁴³ Consequently, broker-dealers actively sought investment graded securities from at least two of the designated NRSROs.

By the SEC’s own admission, the ‘No Action Relief’ letters were from the onset issued to CRAs subsequent to an “informal examination of the agency’s operations, its position in the marketplace, as well as considering other factors”. For example, the No Action Relief letter issued by the SEC to the Japan Credit Rating Agency (JCR) noted that among the requirements met in JCR’s application documents included letters from 10 institutional investors “representing that they have "seriously considered" the credit ratings of JCR in the course of making investment decisions for at least the past three years”.⁴⁴ Reliance on the nondescript phrases like “seriously considered” neither establish that institutional investors actually placed reliance on the ratings nor does it provide details as to what a “serious” consideration would involve. This merely underscores the level of

42 17 C.F.R. 240.15c3-1 (Under the Securities Exchange Act of 1934, the Uniform Net Capital Rule, Rule 15c3-1 incorporated the use of ratings issued by the Nationally Recognized Statistical Ratings

Organizations (NRSROs) in reference to determining certain provisions of the Net Capital Rule). See also, Adoption of Amendments to Rule 15c3-1 and Adoption of Alternative Net Capital Requirement for Certain Brokers and Dealers, Exchange Act Release No. 11497 (June 26, 1975), 40 FR 29795 (July 16, 1975).

4317 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H). See alsoSEC Release No. 33-7085; 34-34616; IC-20508, 2 (International Series Release No. 706. File No. S7-23-94, Aug. 31, 1994).

44 SEC, NRSROs general info, http://www.sec.gov/divisions/marketreg/ratingagency.htm.

vagueness and subjectivity exercised by SEC officials in issuing the much coveted NRSRO designation.

The acknowledged (high) level of informality in the designation award process notwithstanding, what the No Action Relief letters meant in practical terms for the fortunate recipients was that the SEC’s Division of Market Regulation would not recommend censure or enforcement action to the Commission if the CRA had been waived for purposes of application of the Net Capital Rule. A ‘No Action Relief’ letter can thus be construed as being equal to a waiver. The result of the exemption from censure, the broker-dealer reduced haircuts and the opaqueness in the NRSRO designation award process, was that the early recipients of the designation were able to enjoy an essentially unchallenged advantage over their peers in the industry. This early advantage benefitted the Big Three to such an extent that it shaped the market structure of the credit ratings industry from then on.

Despite having been in use since 1975 the SEC had, more than two decades later,⁴⁵ still not settled the core issue of defining the terms and requirements necessary for qualifying for an NRSRO designation. Conceding that no actual definition of an NRSRO had been provided,⁴⁶ the SEC decided that all subsequent references to NRSROs should assume the interpretation considered for “purposes of the Net Capital Rule”.⁴⁷ As can be deduced from the NRSRO title, the single criterion deemed most important by the legislators was the requirement for them to be “nationally recognized” by “predominant

45 NRSRO’s definition was first provided by the SEC in CRARA 2006 Act, P.L. 109-291.

46 SEC, Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Market (hereafter, Role and Function Report), 2003 at 15.

47 Rule 2a-7 under the Investment Company Act of 1940, 17 CFR 270, 2a-7 (the term “NRSRO” is defined to mean any NRSRO “as that term is used in Rule 15c3-1…”),

http://www.gpo.gov/fdsys/pkg/CFR-2012-title17-vol2/pdf/CFR-2012-title17-vol2-sec230-436.pdf

users of ratings in the United States as an issuer of credible and reliable ratings”.⁴⁸ Moreover, the SEC in 1997 recognized that although “initially adopted by the Commission in 1975 for the narrow purpose of distinguishing different grades of debt securities under the Commission’s net capital rule… [the] NRSRO concept ha[d]

expanded beyond its originally intended use”⁴⁹.

The enactment of the Credit Rating Agency Reform Act of 2006⁵⁰ sought to add clarity to the matter by setting aside reliance on the No-Action Letters by requiring CRAs to register as NRSROs with the SEC. This change paved the way for other credit ratings firms like Egan-Jones whose initial application for NRSRO status accreditation had been submitted in 1997 to finally received accreditation in December 2007.⁵¹

2.3. Summing up

The creation of the NRSRO designation ensured that a select few accredited CRAs were able to increase their deal-flow, their revenue base and consequently their market share. This occurred predominantly because their opinions had become a legal

48 Appendix No.1 for full statement of requirements reviewed by the SEC when evaluating applications for NRSRO designation.

49 SEC, 62 Federal Register 249, Capital Requirements for Brokers or Dealers Under the Securities Exchange Act of 1934, 68018-024, at 68019, http://www.gpo.gov/fdsys/granule/FR-1997-12-30/97-33402/content-detail.html.

50 Public Law 109–291. 120 Stat. 1327 (2006).

51 HERWIG M.LANGOHR &PATRICIA T.LANGOHR, THE RATING AGENCIES AND THEIR CREDIT RATINGS, 403 (John Wiley & Sons Ltd, 2008).

requirement for many market participants. Partnoy,⁵² Hill⁵³ and other scholars⁵⁴ have postulated that the SEC’s approach revolutionized the role and function of CRAs by driving them from being merely private party agents to becoming de facto licensing agents. The apparent absence of clarity and/or motivation from the SEC on the exact requirements necessary for other CRAS to qualify for NRSRO status meant that the initial designees enjoyed first-mover advantage which enabled them to both consolidate and expand their market share.⁵⁵

52 Frank Partnoy, How and Why Credit Rating Agencies are Not Like Other Gatekeepers, 58, 82 (Uni. of San Diego, School of Law. Legal Studies Research Paper Series, Research paper No. 07-46, 2006); Frank Partnoy, The Siskel and Ebert of Financial Markets? Two Thumbs Down for the Credit Rating Agencies, 77 WASH.U.L.Q.REV. (3) 619, 623 (1999).

53 Claire A. Hill, Regulating the Rating Agencies, 82 WASH.U.L.Q.43, 81 (2004).

54 e.g., IOSCO, Ratings in structured finance: what went wrong and what can be done to address shortcomings, Comm. on the Global Fin. Sys., No. 32, at 9 (2008). (“[A] credit rating, then, is

occasionally viewed as not only a CRA’s opinion of the loss characteristics of the security, but also as a seal of approval.”).

55 Aline Darbellay & Frank Partnoy, Credit Rating Agencies and Regulatory Reform, 3 (Research Handbook on the Economics of Corporate Law, San Diego Legal Studies Paper No. 12-082, 2012) (the poor performance of structured product ratings is primarily the result of executive directives to maintain and gain market share from competitors), and Fabian Dittrich, The Credit Rating Industry: Competition and Regulation, Note, at 80-81 (2007).