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special to the national law journal Sandeep Gopalan, who formerly worked as an investment banker on Wall Street, is studying for a doctorate in law at The Queen’s College, Oxford University. For years, credit rating agencies have operated in the nether world of the law, facing little regulation-and even less competition-and have evolved into a lazy cartel. The collapse of Enron, just four days after being rated a good credit risk, forced a close, hard look that took too long in coming. The staff report issued on the Enron situation in connection with the investigation by the Senate Committee on Governmental Affairs found that the monitoring and review of Enron’s finances by its credit rating agencies “fell far below the careful efforts one would have expected from organizations whose ratings hold so much importance.” The report damningly noted that the agencies seemed to have paid very little attention even to Enron’s public filings. In June, the Securities and Exchange Commission (SEC) sought comments on various questions, including whether credit rating agencies should be regulated and the extent and nature of such regulation. It is certain that the current state of affairs cannot be allowed to continue. The investing public’s faith in the rating system needs to be restored. When bodies that are the repositories of public trust have been shown to be unable to keep their houses in order, the law has little choice but to step in. Regulation needs to cover all aspects of the business. Credit rating agencies entered the legal realm under the rather jargonistic title “nationally recognized statistical rating organizations,” or NRSROs, and are currently accorded recognition by the SEC through the no-action letter process. There are just three NRSROs-Moody’s, Fitch and Standard & Poor. While one may argue that there is not much room for more players in the market given that certainty and consistency are the ruling deities, the fact that just three companies run an industry of such profitability and magnitude alone suffices to raise more than the suspicious eyebrow. More competition is a worthy goal of legal intervention. Too hard to enter Why are there only three players? Regulatory barriers to entry is the primary reason. The SEC has been known to sit on applications for NRSRO status for eight years, only to deny it. Certainly not the best advertisement for competition. The single most important factor in the SEC’s assessment of NRSRO status is whether the rating agency is “nationally recognized” in the United States as an issuer of credible and reliable ratings by the predominant users of securities ratings. It also reviews the applicant’s operational capability and reliability, with particular regard to its organizational structure, financial resources and independence, the size and quality of the staff, its rating procedures and internal confidentiality procedures. Some of these criteria are questionable. For example, how on earth is an applicant to have national recognition prior to conferment of NRSRO status? While the ratings process should be reliable, it would suffice to establish qualitative checks on the information generated, rather than resort to gatekeeper controls that restrict competition. Even if we keep the present set of standards, they must be embodied in black-letter law, and the SEC must be saddled with the burden of making decisions in a time-bound manner to avoid uncertainty. There is also debate about disclosure requirements that must be imposed. Credit raters supplement their public sources with nonpublic information-such as credit agreements, acquisition agreements, private-placement memoranda and business projections. It is this nonpublic information that is the bone of contention. There are two competing interests: arguably more reliable ratings derived from access to nonpublic information, and uncertainty caused by nondisclosure of reasons for the ratings. As there is little value in ratings that rely solely on publicly available information, we should err toward greater use of nonpublic sources, in the hope that the compromise on disclosure will be justified by greater accuracy. It is absurd to continue to expect ratings agencies to be our guardians of credit risk, without bringing them within the pale of the law. The harsh light of the law must shine at least on the qualitative aspects of information that is disseminated. Not only must the law impose standards for recognition, it must require explanations for ratings. There must also be some solution for the vexing conundrum posed by conflicts of interest caused by issuers paying for their own credit ratings. Credit raters must not be allowed to hunt with the hounds and run with the hares.

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