• How did the rating agencies miss anticipating recent corporate failures? In their testimony, the rating agencies maintain that they are dependent on the integrity of the financial reports provided by external auditors. However, the Senate staff report concluded that there was a "disappointing lack of diligence in their coverage and assessment" with regard to Enron, given their access to confidential documents and plans provided to rating agencies by companies. Still, most observers have concluded that corporate failures are difficult if not impossible to anticipate, particularly if there is intent to disguise the true nature of business transactions.
  
  
• Do adequate protections exist for investors, lenders and others who are dependent on ratings? When lawyers, accountants and physicians err, they can be disciplined by their regulators and/or by lawsuits seeking civil damages. No such relief pertains to raters, who are neither regulated or subject to legal action. For example, Colorado and California debt issuers (a school district and an HMO) sued rating agencies (Moody's and a small agency, the Weiss Group, respectively) for libel and defamation on the grounds of adverse market reaction to unsolicited opinions. However, these suits were dismissed on the grounds of an ostensibly objective rating process and the free speech protections of the First Amendment.
  
  
• Are the raters competent to do their evaluations? The special position of the NRSROs implies that analysts be adequately qualified to perform company reviews, including academic attainments (such as an MBA), professional certification (a CPA), and credit rating and industry experience. The Senate report noted that raters did not probe and consider disclosures and statements presented by Enron, and relied instead on the word of company executives. It is difficult to refute the argument that credentialing standards are appropriate in credit rating decisions, although the raters maintain that concerns for their reputation are sufficient to ensure the required level of expertise.
  
  
• Should the NRSROs disclose how their ratings are developed? A credit rating reflects a rating agency's opinion, as of a specific date, of the creditworthiness of a particular company, security or obligation. During the past three decades, the SEC and other regulators have increasingly used credit ratings to help monitor the risk of investments held by regulated entities. Ratings impact a company's access to and cost of capital, and the structure of its financial transactions. Despite the critical nature of a rating, the NRSROs have never explained (other than in the most general terms) how decisions are made, which criteria are examined and whether the process is fair and objective.
  
  
• Should the SEC ease the qualification process for the NRSRO designation? Despite the recent admission of Dominion to the "NRSRO club," the rating business has, historically, been dominated by Moody's and Standard and Poor's, with some inroads by Fitch. The NRSRO designation itself may be a barrier to entry, in that new entrants cannot be nationally recognized because companies naturally gravitate to the current group of raters. Moreover, the SEC's procedures for NRSRO recognition are lengthy and not at all clear to applicants. There seems little dispute that the designation process needs simplification to promote competition among raters; a few observers even believe that the designation should either be reconfigured or eliminated.
  
  
• Do potential conflicts of interest arise from the practice of raters being compensated by issuers? In the past decade, the NRSROs have shifted their method of compensation from investor-based to issurer-based fees. As a result, some observers believe that an inherent conflict of interest arises with companies "paying" for their ratings. There is some evidence that raters may have "pulled their punches" in situations such as Enron and WorldCom, and the NRSROs now claim that remedial actions have been taken to assure the integrity of future decisions.

Likely Outcomes
Congress and the SEC are under pressure to act, and certainly want to do so prior to any new corporate disaster. It's likely that some legislative or regulatory actions will include:

• Specification of required qualifications for ratings analysts, probably by an internal team or group, that will include accounting, financial, management and industry experience and education.
  
  
• Continuation of the NRSRO (or similar) designation, with liberalization of the rules for attainment of the designation and mandatory periodic review by the SEC and capital market participants.
  
  
• Disclosure of the procedures used by the NRSROs for developing and changing ratings. This should encourage a thoughtful review of the adequacy of a rating agency's process and stimulate innovation in the development of new approaches, including the use of models and statistical analyses.
  
  
• Development of remedies when the ratings process fails, including regulatory oversight and/or judicial review.

Conversely, there are two areas where change is less likely. First, the SEC will not require public dissemination of ratings, primarily because of the confidential nature of the relationship between the NRSROs and companies, but also because fees are paid to secure ratings. The second area involves actions to assuage possible conflicts of interest arising from payment for ratings (or the provision of such ancillary services as advice on future business plans). In this instance, the raters have their reputations at risk, and do not need additional supervision to assure their integrity.