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Credit Rating Agencies

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 Chapter-14: Credit Rating Agencies
Michael C Nwogugu
P O Box 996
Newark, NJ 07101,USA
Mcn2225@aol.com;mcn111@juno.com

14.1 Lack Of Independence Of Rating Agencies, And The Constitutionality Of Un-

Solicited Ratings Opinions.
Rating agencies are prone to various problems that arise from their regulation and
the methods by which they are compensated1. Ratings Agencies often actively

1
See: Champsaur A (May 2005). The Regulation Of Credit Rating Agencies In The US And The
EU: Recent Initiatives And Proposals. Un-Published LL.M. Thesis; Under the Supervision of Professor
Howell E. Jackson. Harvard Law School, Massachusetts, USA.
http://www.law.harvard.edu/programs/pifs/pdfs/amelie_champasaur.pdf.
See: Mason J & Rosner J (2007). Where Did the Risk Go? How Misapplied Bond Ratings Cause
Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions.
http://www.hudson.org/files/publications/Hudson_Mortgage_Paper5_3_07.pdf
See: Kerwer D (2001). StandardizAing as Governance: The Case of Credit Rating Agencies 3
(MPI Collective Goods, Preprint No. 2001/3, 2001), available at http://ssrn.com/absract=269311
(“Despite the fact that rating agencies have become increasingly influential in global financial
markets, it is very hard to hold them accountable for their action: rating agencies almost never
have to justify their decisions, let alone provide compensation to others for the adverse
consequences of their mistakes.”).
See: Altman, E I. & Saunders A (2001). An Analysis and Critique of the BIS Proposal on Capital
Adequacy and Ratings. Journal of Banking and Finance, 25: 25-46.
See: Basel Committee on Bank Supervision (August 2000). Credit Ratings and Complementary Sources of
Credit Quality Information. Working Paper No. 3 (August 2000).
See: White L J (2002). The Credit Rating Industry: An Industrial Organization Analysis,"
in Ratings, Rating Agencies and the Global Financial System. Edited by Richard M.
Levich, Giovanni Majnoni, and Carmen Reinhart (Boston: Kluwer, 2002). pp. 41-63.
See: Löffler G (2004). An Anatomy of Rating Through the Cycle. Journal Of Banking &
Finance, 28: 695-670. (“……..There is plenty of academic and anecdotal evidence which
suggests that agency ratings do not fully reflect available information……….”).
See: Reiss D J (September 2, 2005). Subprime Standardization: How Rating Agencies Allow
Predatory Lending to Flourish in the Secondary Mortgage Market. Florida State University Law
Review, Vol. 33, 2006 Available at SSRN: http://ssrn.com/abstract=797164
See: Finch N (March 2004). International Rating Agencies And Sustainability. Working Paper, Macquarie
University. (finding that the majority of rating methodologies currently in use are unacceptable,
and that the cooperative rating is the superior methodology “…..the ratings issued by a rating
agency can generally be classified as either a solicited, unsolicited or cooperative. This classification is
used to distinguish the rating methodology upon three key attributes: (1) whether the company being rated
has requested the rating; (2) whether the company being rated has paid the agency for the rating; and (3)
whether the information source used by the rating agency relies on confidential and non-public information.
The cooperative rating is a form of unsolicited rating where the rated organization co-operates with the
rating agency to provide additional sources of non-public information. This co-operation by the
company to provide additional information helps to improve the reliability of the rating and
therefore its acceptability to users……….”). Available at:
participate in the structuring of securities, instead of passively rating securities – this
represents a major conflict of interest2 – the conduct of ratings agencies in the ratings
process meets the definition of “underwriter”3. The International Organization of
Securities Commissions has issued statements and proposed codes for Credit rating

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=658082.

See: Schwarcz S L (2002). Private Ordering of Public Markets: the Rating Agency Paradox.
University Of Illinois Law Review, _______. (“…….Because rating agencies make their rating
determinations based primarily on information provided by the issuer of securities, a rating is no
more reliable than that information. Ratings thus do not cover the risk of fraud…….”).
See: Hill C A (2004). Regulating the Rating Agencies. Washington Law Quarterly, 82: 43-53
(the current regulatory regime “ doesn’t scrutinize rating agency performance with a view toward
imposing penalties for bad performance. Neither, it seems do the courts”).
See: Bottini F A (____). An Examination of the Current Status of Rating Agencies And
Proposals for Limited Oversight of Such Agencies. San Diego Law Review, 30: 579-589.

See: Hill C A (2003). Rating Agencies Behaving Badly. Connecticut Law Review, 35: 1145-
1155.

2
See: Riddiough T & Chiang R (2003). Commercial Mortgage-Backed Securities: An
Exploration into Agency, Innovation, Information, and Learning in Financial Markets.,
Available at:
(http://scholar.google.com/scholar?hl=en&lr=&safe=off&q=cache:tgPHB82FijQJ:www.
nchu.edu.tw/Fin/03_research/fin2003/Commercial%2520Mortgage-
Backed%2520Securities.pdf+riddiough+chiang+“Commercial+Mortgage-
Backed+Securities. (states in part “.........instead of assuming a passive credit quality certification
role, the rating agency actively controls security architecture and are instrumental in determining
product design standards...........”).

3
Under the 1933 Securities Act, the term “underwriter” includes “any person who… has a direct or
indirect participation in any such undertaking, or participates or has a participation in the direct or
indirect underwriting of any such undertaking…” The concept of “collateral participation”
encompasses many of the functions of, and services now being rendered by credit rating agencies.
Under US federal securities laws, any person who participates in or “takes part in” an underwriting is
subject to Section-11 liability.
See: Naomi O. Harden et al. v. Raffensperger, Hughes & Co., Inc., 94 U.S. 2892 (7th Cir. 1995),
available at
http://caselaw.lp.findlaw.com/cgi-bin/getcase.pl?court=7th&navby=case&no=942892;
Harden v Raffensperger, Hughes & Co., Inc., available at
http://caselaw.lp.findlaw.com/scripts/getcase.pl?court=7th&navby=case&no=942892
Agencies 4. The European Commission has also debated regulation of Credit Rating
Agencies5. This Chapter introduces some solutions to the conflicts of interest inherent in
rating agencies.

Unfortunately, rating agencies have a dis-proportionate and major effect on

capital markets and on on regulation6 – many securities and capital markets statutes are

4
See: Proposed Revision Of IOSCO Code (May 2008) -
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD270.pdf.
See: IOSCO (December 2004). Code of Conduct Fundamentals for Credit Rating Agencies.
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD180.pdf.
See: IOSCO: Report on the Sub-prime Crisis – Final Report, Report of the Technical Committee
of IOSCO. Available at www.iosco.org.
See: IOSCO: The Role of Credit Rating Agencies in Structured Finance Markets – Final Report.
Available at www.iosco.org.
See: http://www.iosco.org/pubdocs/pdf/IOSCOPD153.pdf;
http://www.iosco.org/pubdocs/pdf/IOSCOPD151.pdf;
http://www.iosco.org/pubdocs/pdf/IOSCOPD180.pdf.
See: IOSCO (Feb. 2007). Review of Implementation of the IOSCO Fundamentals of a Code of
Conduct for Credit Rating Agencies, Report of the Technical Committee of IOSCO. Available at
www.iosco.org.
See: CFA Institute Center (Feb. 2008). CFA INSTITUTE CENTRE ENCOURAGED BY GLOBAL
REGULATORS' FOCUS ON CREDIT RATING AGENCY INDUSTRY REFORM.
http://www.cfainstitute.org/aboutus/press/release/08releases/20080205_02.html.

5
See: European Commission (March 2006). Communication On Credit Rating Agencies.
Available at: http://eur-
lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2006:059:0002:0006:EN:PDF.
See: European Union (Oct. 2006). Credit rating agencies. Available at:
http://europa.eu/scadplus/leg/en/lvb/l33227.htm; http://eur-
lex.europa.eu/smartapi/cgi/sga_doc?smartapi!celexplus!prod!DocNumber&lg=en&type_doc=Dir
ective&an_doc=1993&nu_doc=6; http://europa.eu/scadplus/leg/en/lvb/l24036e.htm;
http://europa.eu/scadplus/leg/en/lvb/l24035.htm.
See: E.U. Parliament Committee on Economic and Monetary Affairs (Rapporteur G. Katiforis) (January 29,
2004). Report on Role and Methods of Credit Rating Agencies, A5-0040/2004. Available at:
http://www2.europarl.eu.int/omk/sipade2?PUBREF=-//EP//NONSGML+REPORT+A5-2004-
0040+0+DOC+PDF+V0//EN&L=EN&LEVEL=3&NAV=S&LSTDOC=Y.
See: CESR (March 2005). CESR’s Technical Advice to the European Commission on Possible Measures
Concerning Credit Rating Agencies, CESR 05-139b.

6
See: Shuermann T (2004). A Review of Recent Books on Credit Risk. Federal Reserve Bank of
New York (Sept. 2004) (citing numerous studies).
See: Tarashev N A (July 2005). An Empirical Evaluation of Structural Credit Spread Models.
BIS Working Papers, #179.
See: Basel Committee on Banking Supervision (2000). Credit Ratings and Complementary
based on rating agencies7.. Many regulatory agencies have embedded ratings (by rating

Sources of Credit Quality Information. Working Paper #3 (2000) (“……….Ratings-based

financial regulation can potentially alter the incentives that credit rating agencies face. In the
absence of regulatory use of ratings, the only value of ratings to an issuer lies in the credibility of
the signal it sends to potential investors about credit quality. However, the situation changes
when credit ratings determine the conditions, if any, on which an investor may buy a particular
bond. A regulated investor might prefer that a credit rating on a bond simply be high enough so
that it can be included in its portfolio, rather than accurately reflect the issuer’s default risk.
Under such a scenario, it is at least conceivable that an un-principled rating agency would
implicitly collude with a risky issuer and investors wishing to skirt portfolio restrictions by
providing an inflated rating……..”).

7
The new US treasury regulations for credit rating agencies which was submitted to the US
Congress in July 2009 are as follows:

Conflicts of Interest
Bar Firms From Consulting With Any Company That They Also Rate: Credit ratings agencies
will face similar restrictions to other professional service providers, like accountants, and will be
prohibited from providing consulting services to companies that contract for ratings.
Strengthen Disclosure And Management Of Conflicts Of Interest: The legislation will prohibit or
require the management and disclosure of conflicts arising from the way a rating agency is paid,
its business relationships, affiliations or other conflicts.
Disclose Fees Paid By An Issuer Along With Each Rating Report: Each rating report will disclose
the fees paid by the issuer for a particular rating, as well as the total amount of fees paid by the
issuer to the rating agency in the previous two years.
Look-Back Requirement To Address The Conflicts From A “Revolving Door”: If a rating agency
employee is hired by an issuer and if the employee had worked on ratings for that issuer in the
preceding year, the rating agency will be required to conduct a review of ratings for that issuer to
determine if any conflicts of interest influenced the rating and adjust the rating as appropriate.
Designate A Compliance Officer: Each rating agency will be required to designate a compliance
officer – reporting directly to the board or the senior officer of the firm – with direct
responsibility over compliance with internal controls and processes. The compliance officer will
not be allowed to engage in any rating activities, marketing, sales, or setting of compensation; and
will be required to submit a report annually to the SEC.

Transparency & Disclosure

Require Disclosure Of Preliminary Ratings To Reduce “Ratings Shopping”: Currently, an issuer
may attempt to “shop” among rating agencies by soliciting ‘preliminary ratings’ from multiple
agencies and then only paying for and disclosing the highest rating it received for its product. We
would shed light on this practice by requiring an issuer to disclose all of the preliminary ratings it
had received from different credit rating agencies so that investors will see how much “shopping”
happened and whether there were discrepancies with the final rating.

Require Different Symbols To Be Used To Distinguish The Risks Of Structured Products: One of
the challenges in the current crisis was that investors did not fully realize that the risks posed by
structured products such as asset-backed securities are fundamentally different from those posed
by corporate bonds, even with similar credit ratings. Our proposal requires rating agencies to use
different symbols for structured finance products as an indication of these disparate risks.

Require Qualitative And Quantitative Disclosure Of The Risks Measured In A Rating: Agencies
will be required to provide a much fuller picture of the risks in any rated security through the
addition of qualitative and quantitative disclosure of the risks and performance variance inherent
in any given security. Ratings cannot be a substitute for investor due diligence. Therefore, to
facilitate investor analysis, we will require that each rating also include a clear report containing
assessments of data reliability, the probability of default, the estimated severity of loss in the
event of default, and the sensitivity of a rating to changes in assumptions. This report will present
information in a way that makes it simple to compare this data across different securities and
institutions. This additional information will increase market discipline by providing clearer
estimates of the risks posed by different investments.

Strengthen SEC Authority and Supervision

Establish A Dedicated Office For Supervision Of Rating Agencies: Our legislative proposal
establishes a dedicated office within the SEC to strengthen supervision of rating agencies and to
carry out the enhanced regulations required.

Mandatory Registration: Unlike the current voluntary system of registration, our proposal would
make registration mandatory for all credit rating agencies. This will bring all ratings firms into a
strengthened system of regulation.

SEC Examination Of Internal Controls And Processes: The SEC will require each rating agency
to document its policies and procedures for the determination of ratings. The SEC will examine
the internal controls, due diligence, and implementation of rating methodologies for all credit
rating agencies to ensure compliance with their policies and public disclosures.

Reduce Reliance on Credit Rating Agencies

PWG Review of Regulatory Use of Ratings: Treasury will work with the SEC and the President’s
Working Group on Financial Markets to determine where references to ratings can be removed
from regulations.

SEC Recently Requested Public Comment on Whether to Remove References to Ratings in Money
Market Mutual Fund Regulation: As part of a comprehensive set of money market fund reform
proposals, the SEC requested public comment on whether to eliminate references to ratings in the
regulation governing money market mutual funds, as a way to reduce reliance on ratings.
Treasury will work with the SEC to examine opportunities to reduce reliance and increase the
resilience of the money market mutual fund industry.

Require GAO Study On Reducing Reliance: In addition to regulatory efforts to reduce reliance on
credit ratings, this legislation would require the GAO to study and issue a report on the reliance
on ratings in federal and state regulations.

Strongly Support SEC Actions on Credit Rating Agencies

Enable Additional Ratings On Structured Products: Because structured products are often
complex and require detailed information to assess, it can be difficult for a rating agency to
provide “unsolicited ratings” – ratings on products it was not paid to rate. These ratings, while in
existence previously, were ineffective because investors understood that these unsolicited ratings
did not benefit from the same information as the fully contracted ratings. The SEC has proposed a
rule that would require issuers to provide the same data they provide to one credit rating agency
agencies) in various statutes and regulations8, even though there are significant conflicts

as the basis of a rating to all other credit rating agencies. This will allow other credit rating
agencies to provide additional, independent analysis to the market.

Require Disclosure Of Full Ratings History: The SEC has proposed to require NRSROs to
disclose, on a delayed basis, ratings history information for 100% of all issuer-paid credit ratings.

Strengthen Regulation And Oversight Of Credit Rating Agencies: In response to the credit market
turmoil, in February the SEC adopted several measures to increase the transparency of the rating
agencies’ methodologies, strengthen disclosure of ratings performance, prohibit certain practices
that create conflicts of interest, and enhance recordkeeping and reporting obligations to assist the
SEC in performing its regulatory and oversight functions. The SEC has allocated resources to
establish a branch of examiners dedicated specifically to conducting examination oversight of
rating agencies.
8
See: Cantor R (2001). Moody’s Investors Service Response to the Consultative Paper Issued by
the Basel Committee on Bank Supervision “A New Capital Adequacy Framework. Journal Of
Banking & Finance, 25: 171-179 (states in part “………..By using ratings as a tool of regulation,
regulators fundamentally change the nature of the rating agency product. Issuers pay rating fees,
not to facilitate access to the capital market, but to purchase a privileged status for their securities
from the regulator. As a result, licensed rating agencies will have a product to sell regardless of
the analytic quality of their ratings and their credibility with the investor Community……..”).
See: Definition of Nationally Recognized Statistical Rating Organization, 70 Fed. Reg. 21,306,
21,307-08 (Apr. 25, 2005) (to be codified at 17 C.F.R. pt. 240).
See: US Securities & Exchange Commission (2003). Report On The Role And Function Of
Credit Rating Agencies In The Operation Of The Securities Markets, pp. 10-25 (describing the
use of NRSRO ratings in government regulations and legislation).

See: Fons J S (_______). Policy Issues Facing Rating Agencies, in RATINGS, RATING
AGENCIES AND THE GLOBAL FINANCIAL SYSTEM, note 141, at 341.
(“……….Historically, the major rating agencies have been against the use of credit ratings in the
regulatory process due to potential impact of rating changes on financial markets, incentives to
engage in ratings shopping, the accuracy of ratings in reflecting the underlying risks, the use of
ratings as ‘automatic pilot’ substitutes for proper credit analysis by lenders and investors, and the
pressure that might be brought to bear on the agencies if they were to become too closely tied to
the regulatory process—including regulation of the agencies themselves………….”).

See: Levich R, Giovanni M & Reinhart C, eds., (2002). Ratings, Rating Agencies and the Global
Financial System. (Boston: Kluwer, 2002).
See: Partnoy F (1999). The Siskel and Ebert of Financial Markets: Two Thumbs Down for the
Credit Rating Agencies. Washington University Law Quarterly, 77(3): 619-712.
See: Partnoy F (2002). The Paradox of Credit Ratings. In Ratings, Rating Agencies and the
Global Financial System, edited by Richard M. Levich, Giovanni Majnoni, and Carmen Reinhart.
(Boston: Kluwer, 2002), pp. 65-84.
See: U.S. Securities and Exchange Commission (Jan. 2003). Report on the Role and Function of
Credit Rating Agencies in the Operation of the Securities Markets, as Required by Section
702(b) of the Sarbanes-Oxley Act of 2002.
See: U.S. Securities and Exchange Commission (June 4, 2003). Concept Release: Rating
Agencies and the Use of Credit Ratings under the Federal Securities Laws.
of interest in the ratings industry. Ratings are used to determine capital adequacy for
financial institutions, and sometimes to determine thresholds for prosecution and
investigation by government agencies. Most governments don’t have any control over
the quality of the ratings product and over most actions by the rating agencies. In the US,
the recently enacted Restoring American Financial Stability Act (RAFSA) requires some
regulation of ratings agencies and their staff, but does not go far enough. Recent research
in finance shows that asset pricing models of the variety used by credit rating agencies

See: Partnoy, F. (May 2006). How and why credit rating agencies are not like other gatekeepers.
University of San Diego, Legal Studies Research Paper Series, Research Paper No. 07-46, p. 64
See: The Credit Rating Agency Reform Act of 2006, S. 3850.
See: Beaver, W.H., Shakespeare, C. and Soliman, M.T. (2006). Differential properties in the
ratings of certified versus non-certified bond-rating agencies. Journal of Accounting and
Economics, 42: 306–307.
See: Dittrich, F. (2007). The credit rating industry: Competition and regulation. Inaugural PHD
Dissertation. zur Erlangung Des Doktorgrades der Wirtschafts- und Sozialwissenschaftlichen
Fakulta¨t der Universita¨t zu Koln, Germany. PHD Thesis.
See: IOSCO (2008). The role of credit rating agencies in structured finance markets. Final
Report, May 2008.
See: Borio, C. (March 2008). The financial turmoil of 2007–? A preliminary assessment and
some policy considerations. Monetary and Economic Department, BIS Working Papers No. 251,
p. 11.
See: Kuhner, C. (2001). Financial rating agencies: Are they credible? — Insights into the
reporting incentives of rating agencies in times of enhanced systemic risk. Schmalenbach
Business Review, 53: 4- 20.
See: Husisian G (1990). What Standard of Care Should Govern the World’s shortest Editorials?:
An Analysis of Bond Rating Agency Liability. Cornell Law Review, 75: 411-460.
See: Madigan P (Oct. 2009). Rating agency reform legislation 'inappropriate and unfair'. Risk
magazine.
See: Mason, J R. & Rosner, J (May 2007). Where Did the Risk Go? How Misapplied Bond
Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market
Disruptions. Available at SSRN: http://ssrn.com/abstract=1027475.
See: Rousseau S (20005). Enhancing The Accountability Of Credit Rating Agencies: The ase For
A Disclosure Based Approach. Available at:
http://www.rotman.utoronto.ca/cmi/papers/CRA_Study_Rousseau.pdf.
See: Champsaur A (May 2005). The Regulation of Credit Rating Agencies in the U.S. and the
E.U.: Recent Initiatives and Proposals. (unpublished LL.M. dissertation, Harvard Law School),
available at http://www.law.harvard.edu/programs/pifs/pdfs/amelie_champasaur.pdf.
See: Fitzgerald F M (December 2002). The Use of Insurance Credit Scoring In Automobile and
Homeowners Insurance: A Report to the Governor, the Legislature and the People of Michigan.
Available at: http://www.michigan.gov/documents/cis_ofis_credit_scoring_report_52885_7.pdf.
See: White L J (2006). Good Intentions Gone Awry: A Policy Analysis of the SEC’s Regulation
of the Bond Rating Industry. New York University Law and Economics Research Paper #06-36;
Networks Financial Institute Policy Brief, No. 2006-PB-05, April 2006. available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=923566 (proposing that financial regulators
should “cease delegating their safety-and soundness judgments to” privileged raters).
fail to explain real world data. For example, observed market spreads typically are much
higher than those predicted by structural models, especially at the high quality end of the
rating spectrum. These studies suggest that there are significant non-credit components to
spreads on fixed-income instruments. Moreover, such models fail to take into account tail
risk, and are based on historical measures, which often are not good predictors.
Although investors and regulators perceive credit ratings as accurate indicators of
credit risk, legislators, courts and regulators both in the U.S. and the E.U. consistently
define them as opinions and consider that there should be no substantive regulation of
credit rating methodologies. U.S. courts stated that investors’ reliance on credit ratings as
though they were “guarantees” of a certain level of credit risk was “unreasonable”9.

Table-___: Major International Rating Agencies By Rating Type And Classification Of Independence

Mutual Corporate
Insurance Credit Funds Sovereign Governance Sustainability
A.M. Best Company Solicited - - - - -
& Un-
Solicited
ASSIRT - - Solicited - - -
Deminor Corporate Governance Rating - - - - Solicited & -
Service Un-
Solicited
Duff & Phelps Solicited - - - - -
Fitch Ratings - Solicited & - Solicited - - - -
& Un-
Solicited
Governance Metrics International (GMI) - - - - Solicited -
Investor Responsibility Research Centre - - - - Un- -
(IRCC) Solicited
ISS Corporate Governance Quotient - - - - Un- -
Solicited
Mercer - - Solicited - - -
Moody’s Investor Services Solicited Solicited - Solicited - -
& Un- & Un-
Solicited Solicited
Morningstar - - Solicited - - -
Rainmaker - - Solicited - - -
RepuTex - - - - - Un-Solicited
&
Cooperative

9
See: Quinn v. McGraw-Hill, 168 F.3d 331 (CA7, 1999).
 Standard & Poor’s (S&P) Solicited Solicited Solicited Solicited Solicited -
& Un- & Un-
Solicited Solicited
Thompson - Solicited Solicited - - -
& Un-
Solicited
Van Eyck - - Solicited - - -
Weiss Ratings Solicited - - - - -
& Un-
Solicited
Sources: Finch (2004); Macquarie University; Industry
data (2010).

14.2 The Constitutionality Of Un-Solicited Ratings Opinions.

The issue of the constitutionality of un-solicited ratings opinions has been debated
– and the current consensus in the US seems to be that ratings agency opinions dont
violate the Free Speech Clause10.

14.3 The Compensation Of Rating Agencies.

Ratings agencies are not independent, whereas the ratings function requires
complete independence11. Rating agencies are compensated by issuers and or investment
banks, and this creates conflict of interest (before the 1970s, rating agencies were
compensated by bond investors). Investment banks and issuers can and often ‘shop’ for
the most favorable ratings. Under the current industry structure, banks and or issuers pay
for the ratings service only after the transaction is closed, and if they are not pleased with
the assigned ratings, they will typically ask a second rating agency to rate the securities
(without paying the first rating agency) and all this typically occurs with investors’

10
See: U.S. Department of Justice (Oct. 2009). Constitutionality of Mandatory Registration of
Credit Rating Agencies. http://www.justice.gov/olc/2009/opinion-letter-treasury.pdf.
See: Cahill Gordon & Reindel LLP (July 2005). Memorandum On the constitutionality of H.R.
2990, the “Credit Rating Agency Duopoly Relief Act of 2005”. Available at:
http://www2.standardandpoors.com/spf/pdf/media/Exhibit_2.pdf.

11
See: US Securities & Exchange Commission (January 2003). Report on the Role and Function
of Credit Rating Agencies in the Operation of the Securities Markets - As Required by Section
702(b) of the Sarbanes-Oxley Act of 2002.
knowledge. The New York State Attorney General’s Office has entered into binding
agreements with most rating agencies about their compensation12.

12
See: Office Of The New York State Attorney General (June 2008). Attorney General Cuomo
Announces Landmark Reform agreements With The Nation’s Three Principal Credit Rating
Agencies. Available at: http://www.oag.state.ny.us/press/2008/june/june5a_08.html/.
According to a June 2008 Press Release by the office of the New York State Attorney General
“…........Under the agreements with Attorney General Cuomo, the credit rating agencies will
fundamentally alter how they are compensated by investment banks for providing ratings on loan
pools. In addition, the ratings firms will all now require for the first time that investment banks
provide due diligence data on loan pools for review prior to the issuance of ratings. This will
ensure that significant data, which was not previously disclosed to the rating agencies, will be
received and reviewed by them before any bonds are rated. “The mortgage crisis currently
facing this nation was caused in part by misrepresentations and misunderstanding of the true
value of mortgage securities. The tremendous reach of this crisis cannot be understated -- our
entire economy continues to feel aftershocks from the collapse of the mortgage industry,” said
Attorney General Cuomo. “By increasing the independence of the rating agencies, ensuring they
get adequate information to make their ratings, and increasing industry-wide transparency, these
reforms will address one of the central causes of that collapse. The reforms agreed to today by
S&P, Moody’s, and Fitch should begin to restore investor confidence during what is a very
troubling time for the mortgage industry, and I applaud the firms for their cooperation with our
investigation……….……The agencies were paid no fees during their initial reviews of the loan
pools or during their discussions and negotiations with the investment banks about the structuring
of the loan pools. Investment banks were thus able to get free previews of RMBS assessments
from multiple credit rating agencies, enabling the investment banks to hire the agency that
provided the best rating. In addition, the Attorney General’s investigation found that credit rating
agencies were not privy to pertinent due diligence information that investment banks had about
the mortgages comprising the loan pools. The agreements Attorney General Cuomo has reached
with S&P, Moody’s, and Fitch will help ensure the independence of the credit rating agencies,
require the disclosure of due diligence information to the agencies, and increase transparency
throughout the industry. All three rating agencies have agreed to implement the following
reforms:
• Fee Reforms. Credit rating agencies are typically compensated only if they are selected to rate
an RMBS by an investment bank. Credit rating agencies will now establish a fee-for-service
structure, where they will be compensated regardless of whether the investment bank ultimately
selects them to rate a RMBS.
• Disclosure Reforms. Credit rating agencies will disclose information about all securitizations
submitted for their initial review. This will enable investors to determine whether issuers sought,
but subsequently decided not to use, ratings from a credit rating agency.
• Loan Originator Review. Credit rating agencies will establish criteria for reviewing individual
mortgage lenders (known as originators), as well as the lender’s origination processes. The credit
rating agencies will review and evaluate these loan originators and disclose their originator
evaluations on their websites.
• Due Diligence Reforms. Credit rating agencies will develop criteria for the due diligence
information that is collected by investment banks on the mortgages comprising an RMBS. The
credit rating agencies will receive loan level results of due diligence and review those results
prior to issuing ratings. The credit rating agencies will also disclose their due diligence criteria on
their websites.
• Credit Agency Independence. Credit rating agencies will perform an annual review of their
RMBS businesses to identify practices that could compromise their independent ratings. The
14.2 Effective Compensation Models For Rating Agencies.
The properties of an efficient Incentive Compensation System for ratings agencies
are as follows:

a) The Incentive Compensation System (ICS) must reduce information assymetry in the
market.
b) The ICS must reduce ratings-shopping by companies and investment banks.
c) The ICS must be source neutral – ICS must not be paid directly from the client
company or the investment bank.
d) The ICS
e)

The following are various alternatives for the compensation of Rating Agencies –
the alternatives are designed to reduce conflicts of interest.

Alternative One: Each rating agency will be able to rate any security that it wants and
when it wants, without any interference from the issuer – hence, the rating agency’s
revenue generation process will not depend on the issuer or the investment bank; and
rating agencies can become profitable simply by rating seasoned securities and earning
fees from subscribers in addition to fees paid from the “Investor Pool” and the “Agency
Pool”. The only condition is that the rating agency must provide a one year Ratings
Warrantee which is described below. The Rating Agencies should be compensated by: a)
a base fee paid by the issuer which will cover the Rating agency’s evaluation costs,
regardless of whether or not the offering is done or whether the agency’s rating is

credit ratings agencies will remediate any practices that they find could compromise
independence.
• Representations and Warranties. Credit rating agencies will require a series of representations
and warranties from investment banks and other financially responsible parties about the loans
underlying the RMBS………”.
accepted – this fee will not exceed 40% of the total fees earned by the Rating Agency
from the transaction; plus b) fees from an “Agency pool” which will be maintained by the
US SEC – these additional fees will depend on the dollar amount of the transaction, and
the relative complexity of the transaction. The Agency Pool will be funded from: a)
special taxes on proceeds of rated bond offerings that will be paid to issuers; b) a tax on
audit fees (on CPA firms) earned from auditing any issuer of rated bonds or borrower of
rated bank loans.

Alternative Two: Each rating agency will be able to rate any security that it wants
and when it wants, without any interference from the issuer – hence, the rating agency’s
revenue generation process will not depend on the issue or the investment bank; and
rating agencies can become profitable simply by rating seasoned securities and earning
fees from subscribers in addition to fees paid from the “Investor Pool” and the “Agency
Pool”. The only condition is that the rating agency must provide a one year Ratings
Warrantee which is described below. The Rating Agencies should be compensated by: a)
a Transaction Fee paid by the issuer, which will not exceed 30% of the total fees earned
by the Rating Agency – the issuer must pay this fee regardless of whether or not the
offering is done or whether the agency’s rating is accepted by the issuer; b) a Base Fee
paid by an Investor Pool, which will cover the Rating agency’s evaluation costs,
regardless of whether or not the offering is done or whether the agency’s rating is
accepted; plus c) a Transaction Fee paid from an Agency pool which will be maintained
by the US SEC. The Investor Pool will be maintained by a trustee appointed by the US
SEC, and will be funded by the following: a) special annual levies on securities accounts
based on the amount of assets in the account, b) special levies on each bond transaction,
which will be paid by the issuer, c) a fixed fee paid by the SIPC for every transaction that
requires a rating, d) a fee levied on bond insurers for every transaction. The Agency Pool
will be operated by a trustee appointed by the US SEC, and will be funded from: a)
special taxes on rated bond offerings, b) a special levy on audit fees (on CPA firms)
earned from auditing any issuer of rated bonds or borrower of rated bank loans.

Alternative Three: Each rating agency will be able to rate any security that it
wants and when it wants, without any interference from the issuer – hence, the rating
agency’s revenue generation process will not depend on the issue or the investment bank;
and rating agencies can become profitable simply by rating seasoned securities and
earning fees from subscribers in addition to fees paid from the “Investor Pool” and the
“Agency Pool”. The only condition is that the rating agency must provide a one year
Ratings Warrantee which is described below. The Rating Agencies should be
compensated by: a) a Base Fee paid by an Investor Pool, which will cover the Rating
agency’s direct evaluation costs, regardless of whether or not the offering is done or
whether the agency’s rating is accepted; plus b) fees from an Agency pool which will be
maintained by the US SEC – which will cover the Rating Agency’s overhead plus profits;
c) A Transaction Fee paid by the issuer, which will not exceed 30% of the total fees
earned by the Rating Agency – the issuer must pay this fee regardless of whether or not
the offering is done or whether the agency’s rating is accepted by the issuer. The
Investor Pool will be maintained by the SEC. The Investor Pool will be funded by the
following: a) special fees levied on all securities accounts, b) special fees levied on each
bond transaction, c) a fee paid by the SIPC, d) a fee levied on bond insurers for every
transaction, e) special fees levied on bank loan transactions. The Agency Pool will be
administered by the SEC. The Agency Pool will be funded from: a) special levies on
proceeds from rated bond offerings that are paid to issuers, b) special taxes on bond
insurers,

Alternative Four: Each rating agency will be able to rate any security that it
wants and when it wants, without any interference from the issuer – hence, the rating
agency’s revenue generation process will not depend on the issue or the investment bank;
and rating agencies can become profitable simply by rating seasoned securities and
earning fees from subscribers in addition to fees paid from the “Investor Pool” and the
“Agency Pool”. The only condition is that the rating agency must provide a one year
Ratings Warrantee which is described below. The Rating Agencies should be
compensated by: a) a Base Fee paid from an Investor Pool, which will cover the Rating
agency’s full evaluation costs, regardless of whether or not the offering is done or
whether the agency’s rating is accepted; b) A Transaction Fee paid by the issuer, which
will not exceed 30% of the total fees earned by the Rating Agency – the issuer must pay
this fee regardless of whether or not the offering is done or whether the agency’s rating is
accepted by the issuer. If a rated investment grade bond defaults within the first two
years of issuance, the Rating Agency must pay a penalty fee, which will be distributed to
bond holders. If a rated bond is assigned a two-step negative (downward) ratings
transition by any competing rating agency within one year of the original rating or a
revised rating, then the other rating agencies must pay a penalty fee to bond holders. The
Investor Pool will be maintained by the SEC. The Investor Pool will be funded by the
following: a) special fees levied on all securities accounts, b) special fees levied on each
bond transaction, c) a fee paid by the SIPC, d) a fee levied on bond insurers for every
transaction, e) special fees levied on bank loan transactions; f) special levies on proceeds
from rated bond offerings that are paid to issuers, b) special taxes on bond insurers,

Alternative Five: Each rating agency will be able to rate any security that it wants
and when it wants, without any interference from the issuer – hence, the rating agency’s
revenue generation process will not depend on the issue or the investment bank; and
rating agencies can become profitable simply by rating seasoned securities and earning
fees from subscribers in addition to fees paid from the “Investor Pool” and the “Agency
Pool”. The only condition is that the rating agency must provide a one year Ratings
Warrantee which is described below. The Rating Agencies should be compensated by: a)
a Base Fee paid from an Investor Pool, which will cover the Rating agency’s fixed costs,
regardless of whether or not the rating agency does any ratings project during the year -
the fixed costs will include a percentage of employee salaries/benefits, G&A costs,
software costs and certain maintainance costs; b) a Base Fee paid from an Investor Pool,
which will cover a percentage of the Rating agency’s variable evaluation costs, regardless
of whether or not the offering is done or whether the agency’s rating is accepted; c) A
Transaction Fee paid by the issuer, which will not exceed 30% of the total fees earned by
the Rating Agency – the issuer must pay this fee regardless of whether or not the offering
is done or whether the agency’s rating is accepted by the issuer. If a rated investment
grade bond defaults within the first two years of issuance, the Rating Agency must pay a
penalty fee, which will be distributed to bond holders. If a rated bond is assigned a two-
step negative (downward) ratings transition by any competing rating agency within one
year of the original rating or a revised rating, then the other rating agencies must pay a
penalty fee to bond holders. The Investor Pool will be maintained by the US Congress.
The Investor Pool will be funded by the following: a) special fees levied on all securities
accounts, b) special fees levied on each bond transaction, c) a fee paid by the SIPC, d) a
fee levied on bond insurers for every transaction, e) special fees levied on bank loan
transactions; f) special levies on proceeds from rated bond offerings that are paid to
issuers, b) special taxes on bond insurers,

Alternative Six: The Government (eg. US Congress) will create and staff a
government ratings agency. This rating agency will be funded by the following: a)
special fees levied on all domestic securities accounts, b) special fees levied on each
bond transaction (sales, new issues, swaps), c) a fee paid by the SIPC, d) a fee levied on
bond insurers for every transaction, e) special fees levied on bank loan transactions; f)
special levies on proceeds from rated bond offerings that are paid to issuers, g) special
taxes on bond insurers. This Government ratings agency (GRA) will contract with, and
provide ratings services to various private sector-rating agencies (PSRA). Hence, the all
or most of the actual ratings function in the industry will be done by the GRA. This
resolves the issues of industry capacity, ratings redundancy (where different rating
agencies use the same processes and issue same ratings), and quality differentials. The
PSRAs will serve as marketing, customer relations, ratings review and industry
research/monitoring entities. The GRA will typically render a ratings opinion to the
PSRA, and if the PSRA disagrees with the GRA’s ratings, a special panel will determine
the rating for the entity. Hence, the GRA’s rating on any entity will serve as a “ratings
floor”. The PSRA will pay GRA on a cost-plus-profits basis, for the ratings services at
the end of each month. The GRA will also be paid a fixed quarterly fee from the Investor
Pool. The PSRA will be compensated by: a) a Base Fee paid from an Investor Pool,
which will cover the Rating agency’s fixed costs, regardless of whether or not the rating
agency does any ratings project during the year -the fixed costs will include a percentage
 of employee salaries/benefits, G&A costs, software costs and certain maintainance costs;
b) a Transaction Fee paid from an Investor Pool, which will cover a percentage of the
Rating agency’s variable evaluation costs, regardless of whether or not the offering is
done or whether the agency’s rating is accepted; c) A Transaction Fee paid by the issuer,
which will not exceed 30% of the total fees earned by the Rating Agency – the issuer
must pay this fee regardless of whether or not the offering is done or whether the
agency’s rating is accepted by the issuer. The theory behind this alternative is that: a) the
government often bears most of the costs of inaccurate ratings – costs of bankruptcies,
government bailouts of financial institutions, tax relief, etc., b) centralization of the
ratings effort will reduce information asymmetry, c) ratings have been incorporated into
statutes and regulations worldwide, and hence the government should____________.
The problem with this alternative is that rating agencies are now international – hence,
for this model to work, each country’s government or a regional government or an
economic community (such as the European Union, the African Union, and the
Organization Of Latin American State) will have to create a ratings agency.

Alternative Seven: There are no rating agencies. The government (SEC) will: a)
publish a series of analytical ratios and standard ratings methodologies which banks,
investors and financial institutions will use in evaluating corporate entities and SPVs.
Investment banks will be required to use these ratios in their research reports on
companies and SPVs. The government (SEC) will also “rate” industries, and publish
quarterly reports on each industry. Where any type of ratings is required for regulatory
purposes, the government can construct indices based on the above-mentioned analytical
ratios. This model resolves the problems of conflict of interest, information asymmetry,
ratings redundancy, rating agency compensation, and fraud.

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