Who’s rating the rating agencies? This issue has picked up steam ever since the bankruptcies of Enron, WorldCom, et al. Just as investors wondered why the accounting firms hadn’t spotted the frauds and foolishness that got those companies into trouble, many questioned why the ratings agencies were caught by surprise as well.

Congress is looking into the issue, inviting testimony from, among others, the president of Financial Executives International, Colleen Cunningham. Ms. Cunningham testified before the Senate Banking Committee on March 7, charging that faulty SEC oversight of the industry was responsible for a lack of adequate competition, an absence of accountability, and for allowing rampant conflicts of interest.

Before your eyes glaze over, consider the role played by these companies. The ratings issued by companies like Standard and Poor’s and Moody’s determine borrowing costs for most major corporations, affecting trillions of dollars in debt instruments and hundreds of millions in interest costs.

Moreover, credit ratings can determine whether a company’s debt can legally be held by certain types of investment organizations. Credit ratings also act as a spotlight, bringing to public attention how a company is performing. The recent news, for instance, that Time Warner’s debt rating was being reduced by both S&P and Moody’s, highlighted the real cost of Carl Icahn’s activism. In response to pressure applied by the financier, Time Warner substantially increased its share buyback program, to the detriment of its balance sheet.

According to Ms. Cunningham, the rating agencies are suffering from a lack of healthy competition. There are today only five companies that the SEC has designated as Nationally Recognized Statistical Rating Organizations. They are S&P, Moody’s, Fitch (an up-and-comer), A.M. Best Company, which is mostly involved with insurance companies, and Dominion Bond Rating Service, which is primarily active in Canada. In effect, then, there are only three broad-based NRSROs, even though there are more than 100 agencies operating worldwide.

In effect, being designated an NRSRO by the SEC is to be taken seriously. Many investment company guidelines require ratings issued from an NRSRO. The problem is, the process of securing this designation is opaque and rests on receiving a “no-action letter” from the SEC, rather than definitive approval. The SEC has never made public the names of the companies that have applied for that status, what the ground rules are, or why a particular company has failed to be so designated.

For instance, one of the requirements is that a company be nationally recognized. The problem is, that’s a difficult hurdle unless you already have the SEC designation. As Harvey Pitt, former chairman of the SEC, says, “This is like the old Maxwell Smart routine on the show “Get Smart,” with a sign on the door that read ‘knock before entering’ and then a sign right below saying ‘don’t knock.'”

One firm that has been particularly aggrieved by this policy is Philadelphia based Egan-Jones. This firm has made itself unpopular by eschewing the traditional business model whereby corporations pay for their ratings. (Does that sound like a potential conflict of interest to you?) Instead, Egan-Jones gets paid by investors for their ratings services. Some 400 investment companies around the globe pay Egan-Jones between $8,000 and $28,000 a year for their research. It receives no fees from debt issuers, and does not provide corporations with consulting services, unlike their larger competitors.

Probably even more annoying to S&P and Moody’s is that Egan-Jones has an excellent track record. Egan-Jones got ahead of them in downgrading Enron, WorldCom, and others, months before the larger firms caught on. Considering that S&P and Moody’s tout the value of their ability to acquire “inside information,” the success of Egan-Jones is embarrassing, to say the least.

Given Egan-Jones’s growing investor fan club, it’s shocking that in July, according to a managing director, Sean Egan, “We will mourn the ninth anniversary of our application for NRSRO status.” Amazingly, the company filed with the SEC in 1995, and has never heard a word. “We don’t know whether our application is acceptable, where we are deficient, nothing.” The firm has conducted surveys proving their national recognition, and feels it has earned its NRSRO designation.

Mr. Egan is outspoken about his competitors’ efforts to keep him out of the club. “Now the SEC is saying that we have to make our ratings available to the public at no charge.” He points out that the only companies that would suffer from that requirement are those like Egan-Jones, which derives its revenue selling proprietary research. Mr. Egan connects those dots.

And he is not the only observer skeptical of the relationship between the SEC and the large ratings companies. General counsel for the FEI, Mark Prysock, suggests that the SEC’s current approach, to work with the NRSROs to establish voluntary self regulation, doesn’t address the issue of competition. The SEC is trying to get the NRSROs to establish procedures addressing conflicts of interest, inside information, and ethics. He says, “The financial cost to an agency of losing its NRSRO designation would be huge,” and thus self-policing is not realistic.

Moody’s and S&P sell consulting services to the companies whose debt instruments they rate, creating a potential conflict. A similar practice existed in the accounting industry until it was ruled illegal after all the big bankruptcies. Mr. Pitt says, “Many companies complain that they are induced to purchase services from the rating agencies out of fear that their failure to do so will result in a lower rating.”

Another festering issue is the possible misuse of confidential information given to the credit analysts by corporate managements. Both Moody’s and S&P have large equity research operations, just like the investment banks. In both industries there is concern that information could migrate inappropriately between divisions.

The SEC, according to Mr. Prysock, does not think it has the authority to oversee the credit rating agencies. Also, William Donaldson, during his tenure as chair of the SEC, expressed his unwillingness to intrude into the industry for fear of raising first amendment issues. Mr. Pitt says, “There’s no question the process needs to be more open and transparent. The entire system needs to be reconsidered, to permit fair competition.” Mr. Egan says, “There’s a disconnect between the mandate of the SEC, whose number one job is protecting investors, and its approach to the rating agencies.” It would appear so.