Credit-rating agencies wield enormous power as gatekeepers to the financial markets for companies and even governments. For more than a decade, the Securities & Exchange Commission has wrestled over whether -- and how -- it should act as a watchdog over rating agencies, which operate largely beyond the reach of regulators. Even the barrage of criticism from Congress and bondholders that raters should have uncovered problems sooner at Enron, WorldCom, and other corporate disasters hasn't jolted the SEC into action.
Turns out that what the SEC needed was a push from overseas. European financial authorities are debating their own regulatory scheme for the American-dominated industry, and now the SEC is kicking into high gear. BusinessWeek has learned that the SEC is pursuing two measures to expand its limited role.
First, it is putting the finishing touches on a proposal to clarify the now-obscure process by which it authorizes rating agencies to appraise the creditworthiness of corporate and government bonds. Clearer rules could allow new rivals to muscle into the club of four: Standard & Poor's (which, like BusinessWeek, is a unit of The McGraw-Hill Companies), Moody's Investors Service, Fitch Ratings, and Dominion Bond Rating Service.
The SEC also is trying to forge an agreement on a voluntary code of conduct that would set policies about how debt analysis is done and install safeguards against insider trading and conflicts of interest. To give the code some teeth, the commission probably will ask Congress for authority to require the rating agencies to open their books and records to the SEC. "Currently there is some ambiguity about our authority to examine the agencies," says SEC Commissioner Roel C. Campos.
The SEC is acting to head off a clamor from European securities regulators for tougher rules. European authorities give the agencies a D rating for not spotting problems at troubled companies, including Parmalat, the Italian dairy giant that declared bankruptcy a year ago. The regulators are also rankled by downgrades of venerable European companies, such as German steelmaker ThyssenKrupp, by U.S. agencies.
Raters say they're faulted unfairly by critics on both sides of the Atlantic. They contend that Enron, Parmalat, and similar debacles were cases of fraud. They cite former Enron Assistant Treasurer Timothy Despain, who detailed his efforts to mislead the agencies about Enron's cash flow in a plea agreement on federal criminal charges filed Oct. 5.
The agencies agree broadly with a draft code of conduct drawn up by the Madrid-based International Organization of Securities Commissions. But some of the proposals would cripple the ratings business, they say. Take the notion of letting a company go to arbitration over a disputed grade. Companies "would like a right of appeal to make sure their view is taken into account," explains Philippe Richard, IOSCO's secretary general. But Moody's President Raymond W. McDaniel Jr. warns that arbitration "would have a chilling effect on the independence of ratings." Agencies might feel pressure to inflate ratings to avoid litigation.
After years of citing First Amendment free-speech rights to fend off government oversight, the agencies are cooperating with the SEC. They hope that rules crafted at home will preempt the threat of stiffer regulations abroad.
But the raters may balk at the SEC's insistence that it must be able to conduct periodic inspections to back up even a voluntary code. Raters fear SEC examiners might not stick to reviewing policies and procedures and instead start to second-guess their ratings. "It depends on the definition of what the review would be," says Vickie A. Tillman, S&P's executive vice-president for credit-market services. "We would oppose anything that would infringe upon the rating process itself and its independence." SEC staffers say they have no intention of interfering. Amid persistent questions about the accuracy and timeliness of credit ratings on both sides of the Atlantic, the SEC believes that it's time to end its hands-off approach.
By Amy Borrus in Washington, with Laura Cohn in London