According to some of the authors of these models, there is little incentive  to continue developing these models, as the issue of alternative  compensation models for NRSROs and their possible implementation  appears unlikely to receive much, if any, attention from regulators or  legislators. For example, these authors told us that SEC had not reached  out to them to further discuss these models as part of the 939F  study. While these models  generally are intended to address the conflict of interest in the issuer-pays  model, some comment letters to SEC for its section 939F study described  a number of perceived disadvantages of these models. Comment Letters to SEC Supported Implementing One Alternative Model or Enhancing Existing Rules

During debate on the Dodd-Frank Act, a system similar to the random  selection model was proposed through an amendment to the Securities  Exchange Act of 1934. However, the Dodd- Frank Act provides that upon completion of the section 939F study, SEC  shall, as it determines is necessary or appropriate in the public interest or  for the protection of investors, establish by rule a system for the  assignment of NRSROs to determine the initial credit ratings and monitor  the credit ratings of structured finance products in a manner that prevents  the arranger from selecting the NRSRO that will determine the credit  rating. In issuing any rule, the act requires SEC to give thorough  consideration to the provisions of section 15E(w) of the Exchange Act, as  that provision would have been added by section 939D as passed by the  Senate on May 20, 2010, and SEC must implement the system described  in such section 939D unless SEC determines that an alternative system  would better serve the public interest and the protection of investors. As part of this solicitation of comments, SEC requested that  interested parties use the evaluative framework we developed for our  2010 report to evaluate the section 15E(w) and other alternative  compensation models. The comment period ended in September 2011. Of the 30 comment letters submitted, our  assessments found that 11 generally favored implementing an alternative  compensation model, 13 opposed the implementation of an alternative  compensation model, and 5 did not comment on the need for an  alternative compensation model. Sixteen comment letters either  supported or made suggestions for improving existing SEC rules. Generally, these letters highlighted the need to address the conflict of  interest inherent in the issuer-pays model. Those opposed to the implementation of an alternative compensation  model, including the section 15E(w) model, cited concerns such as  replacing one set of conflicts of interest with another and raised issues  about the cost of implementation. SEC Is Implementing the Dodd-Frank Act and Reviewing Its Authority to Implement the Alternative Compensation Models

The Dodd-Frank Act requires SEC to take a number of actions regarding  its oversight of NRSROs including issuing a number of rulemakings,  establishing an Office of Credit Ratings, and studying, among other  things, the feasibility of an assignment system for the ratings of structured  finance products and alternative means for compensating NRSROs. As of January 2012, SEC  has adopted three final rules that implement all or part of certain  requirements and proposed rules to implement the remaining  requirements. In addition to its work on NRSRO oversight rules, SEC continues to work  on other Dodd-Frank Act requirements related to NRSROs. Although the office  has yet to be established, NRSRO examination staff from SEC’s Office of  Compliance Inspections and Examinations (OCIE), staff from OCIE’s  investment adviser/investment company and broker-dealer examination  groups, and NRSRO specialists from SEC’s Division of Trading and  Markets recently completed the first cycle of annual examinations of each  NRSRO as required by the Dodd-Frank Act. As part of this study, SEC solicited  comment on its authority to implement various alternative compensation  models. Therefore,  obtaining as complete information on the models as available, such as by  consulting with the models’ authors, will be important for SEC to fully  assess each model in order to make its decision and any  recommendations for statutory changes SEC determines should be made  to implement its findings. However, a few of the comment letters discussed potential legal  questions surrounding the implementation of or rulemaking for specific  aspects of certain models, or general constitutional questions. The model authors also hold varying opinions on the extent to which  statutory changes would be necessary to implement their alternative  compensation model. Alternatively,  the author of the proposed investor-owned credit rating agency model we  interviewed believes that current law, even before the Dodd-Frank Act  was passed, provides SEC with the authority to implement the model as a  means of managing the conflicts of interest generated by the issuer-pays  model. As previously discussed, SEC has not  spoken to the authors of the proposed models to solicit additional details  about their models—information that could help inform SEC’s analysis of  the alternative compensation models and its report to Congress  containing any recommendations for regulatory or statutory changes that  it determines should be made to implement the findings of its study. As of January 2012, none of these models  have been fully developed, and given that NRSROs continue to primarily  use the issuer-pays, and to a lesser extent, the subscriber-pays models,  the use of any alternative model or models would likely have to be at the  direction of SEC or Congress. Currently, the staff is reviewing the comment  letters received and evaluating authority issues, however the extent to  which SEC’s existing authorities would allow it to implement any of the  alternative models by rule largely will depend on the system selected. Recommendation for Executive Action

As SEC continues to study the various alternative means for  compensating NRSROs, as well as determine whether a system for the  assignment of initial credit ratings for structured finance products is  necessary or appropriate in the public interest or for the protection of  investors, SEC should consult with the authors to better ensure it has all  available information on the models to make its decision, and include in  its report to Congress any recommendations for statutory changes the  SEC determines should be made to implement the findings of the study. In its  written comments, SEC agreed with our recommendation. The framework can help identify a model’s  relative strengths and weaknesses, potential trade-offs (in terms of policy  goals), or areas in which further elaboration or clarification would be  warranted using the following factors:  Independence.
Why GAO Did This Study

Over the past decade, concerns repeatedly have been raised about the accuracy of credit ratings provided by a number of nationally recognized statistical rating organizations (NRSRO). NRSRO critics often point to the conflict of interest created by the industrys predominant compensation model in which issuers of securities pay the rating agencies for their ratings (issuer-pays model). In 2006, Congress established Securities and Exchange Commission (SEC) oversight over NRSROs, and recently enhanced this authority through the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). This act also requires GAO to study alternative means for compensating NRSROs. This report discusses (1) alternative models for compensating NRSROs and (2) SECs actions to implement the acts requirements specific to its oversight of NRSROs. To do this work, GAO leveraged its 2010 report on NRSROs (GAO-10-782), reviewed comment letters submitted to SEC as part of its study of alternative compensation models, proposed and finalized rules issued under the act; and interviewed SEC staff and authors of alternative compensation models .

What GAO Found

As of January 2012, GAO identified seven alternative models for compensating NRSROs (see table below). These models generally were designed to address the conflict of interest in the issuer-pays model, better align the NRSROs interest with users of ratings, or improve incentives NRSROs have to produce reliable and high-quality ratings. However, the amount of detail currently available for each model varies and none has been implemented. According to some of the authors of the models, there is little incentive to continue developing these models because it appears unlikely they will receive attention from regulators or legislators. For example, these authors noted that SEC had not reached out to them to further discuss these models as part of its ongoing study of alternative compensation models for credit rating agencies.
During debate on the Dodd-Frank Act, a model similar to the random-selection model was proposed through an amendment that would have added a section 15E(w) to the Securities Exchange Act of 1934 (15E(w) model). Although the amendment was not included in the final legislation, section 939F of the Dodd- Frank Act requires SEC to study, among other things, alternative means for compensating NRSROs. It also authorizes SEC to, upon completion of the study, establish by rule a system for assigning NRSROs to determine initial credit ratings and monitor the ratings of structured finance products in a manner that prevents the arranger from selecting the NRSRO that will determine the credit rating should SEC conclude that an alternative system is necessary or appropriate. In issuing any rule, SEC also must give thorough consideration to the section 15E(w) model and implement the model unless it determines that an alternative would better serve the public interest and protect investors. As part of its solicitation of comments for its ongoing study of alternative compensation models, SEC requested that interested parties use the framework GAO developed in the 2010 report on NRSROs to evaluate the section 15E(w) and other models. GAO created this evaluative framework to help identify the relative strengths and weaknesses and potential trade offs (in terms of policy goals) of the models. Based on GAOs analysis of comment letters to SEC, while a number of comment letters generally favored implementing the section 15E(w) model, slightly more opposed the implementation of any of the models. Those supporting the 15E(w) model highlighted the need to address the conflict of interests inherent in the issuer-pays model. Those opposed to the alternative compensation models cited concerns of replacing one set of conflicts of interest with another and the costs of implementation. A number of the letters either supported or made suggestions for improving existing SEC rules. A few comment letters also raised legal questions about the implementation or rulemaking for specific aspects of certain models.
In addition to studying alternative compensation models, SEC has begun to implement a number of Dodd-Frank Act requirements pertaining to NRSROs. These requirements include additional rulemakings related to NRSROs disclosures of performance statistics, credit ratings methodologies, third-party due diligence for asset-backed securities, and analyst training and testing standards. Of nine rulemaking requirements, SEC has adopted three final rules that implement all or part of certain requirements and proposed rules for the remaining requirements. SEC also has been working to establish an Office of Credit Ratings as required by the act. Moreover, SEC examination staff completed the first cycle of annual examinations of each NRSRO as required by the Dodd-Frank Act and published their summary report in September 2011. As part of its study on alternative compensation models for NRSROs, SEC solicited comment on SECs authority to implement various alternative compensation models. According to SEC staff, they are reviewing the comment letters received and evaluating authority issues. Any recommendations for regulatory or statutory changes SEC determines should be made to implement the findings of the study are to be included in their report to Congress, due in July 2012. The model authors opinions of the extent to which statutory changes would be needed to implement their alternative compensation models vary, with one stating that current law provides SEC with the necessary authority and another anticipating the need for legislation. Given that NRSROs continue to primarily use the issuer-pays, and to a lesser extent, the subscriber-pays models, the use of any alternative model or models would likely have to be at the direction of SEC or Congress. However, the extent to which SECs existing authorities would allow it to implement any of the alternative models by rule largely will depend on the alternative model or models selected. Obtaining as complete information on the models as available, such as by consulting with the models authors, will be important for SEC to fully assess each model in order to make its decision and any recommendations for statutory changes SEC determines should be made to implement the findings of its section 939Fstudy.

What GAO Recommends

SEC should consult with the authors of the proposed models to obtain all available information as it considers the various alternative compensation models and any recommendations for
statutory changes SEC determines should be made to implement the findings of its section 939F study. SEC agreed with the recommendation.