COMMERCIAL CREDIT REPORTING

Commercial credit reporting agencies collect credit information on companies and financial institutions and sell this information to other companies, financial institutions, and individuals. Although this information is used for a variety of purposes, it is generally sold to individuals or financial institutions interested in the stock or bond offerings of a particular company or extending business credit to a particular company. The information is gathered from a variety of sources. Of all the commercial credit reporting agencies, Dun & Bradstreet is the oldest and best known. There are also credit agencies, such as Equifax, Experian, and Trans Union, that focus on the creditworthiness of individuals as opposed to commercial concerns. The term "mercantile agencies," although now somewhat dated, is still used in reference to commercial credit reporting agencies.

The word "credit" is based on the Latin word credo which means "I believe" and refers to the trustworthiness of a person, company, or institution to buy or borrow with payment deferred to a future date. Actual goods or capital are transferred in a credit transaction and an essential part of the transaction is a promise to pay in the future according to prescribed terms and conditions. Credit transactions may involve collateral, which is property or equities pledged by the debtor as security should there be a default on payments. Much of modern business is based on credit and creditworthiness. In order to raise money and maintain liquidity, businesses may offer to sell part ownership in the company in the form of stock or they may offer debt instruments such as bonds. Cash may also be borrowed directly from banks, pension funds, or other financial institutions in the form of loans. The granting of credit (lending money) is based on three factors: character, capacity, and capital. Lending on the basis of character involves a moral risk; lending on capacity involves a business risk; and lending on capital involves a property risk. Character refers to integrity and is directly related to trustworthiness. Capacity and business acumen go hand in hand and includes such tangibles as product quality and intangibles such as reputation. Capital is net worth, which is a measurement of the borrower's collateral.

All credit transactions involve risk on the part of the lender. Generally a lender will demand a greater return on investment in the form of higher interest as risk increases; conversely, as risk decreases so does the return on investment or interest paid. Commercial credit reporting agencies rate the risk to the lender of credit transactions. This rating may be done at the behest of the potential debtor or it may be offered for sale to potential lenders. A potential lender is much more likely to lend money if he or she has in hand a rating or evaluation of the risk involved.

The evaluation or rating of potential credit risk has always played a role in credit transactions. This is especially true in the history of the American economy. Local merchants granted credit in the form of goods to farmers, ranchers, and fur trappers. Wholesale merchants granted mercantile credits to retail stores, and especially in America's colonial period English merchants provided liberal credit for American importers. Because of currency shortages much of this credit was in the form of credit instruments, bills of exchange, and promissory notes. In early America more often than not the lender and the borrower knew one another and interacted on a one-to-one basis. Credit evaluations largely turned on personal relationships and personal trust.

As the country and the economy expanded, however, it became increasingly difficult for lenders to make interpersonal credit evaluations. This was especially true by the 19th century when eastern merchants began granting liberal credit terms to businesses on America's frontier, which was expanding ever westward. Blind trust became more and more necessary as distance negated interpersonal credit transactions and, in the case of a default, interpersonal collection. In their book on 19th century business in the United States, Glenn Porter and Harold C. Livesay wrote, "Equally necessary was a knowledge of the credit standing of commercial correspondents (normally other all-purpose merchants). Business conducted in many places across vast distances had to be based on faith in one's creditors, for the forceful collection of overdue bills was difficult if not impossible." There was thus a growing market for hard and reliable credit information.

Dun & Bradstreet, the oldest and best-known credit reporting agency, traces its origins to the Mercantile Agency founded by Lewis Tappan in New York in 1841. Tappan had a network of correspondents or field agents (attorneys, bank cashiers, merchants, etc.) who gathered financial information on merchants and businesses. The agents were required to maintain impartiality in gathering this information, which was subsequently sold to Tappan's subscribers. In 1859 after having undergone a number of ownership changes the business was sold to Robert Graham Dun, who changed its name to R.G. Dun & Co. The business prospered, expanded overseas, and in 1933 merged with its largest competitor, the Bradstreet Company, which was founded in Cincinnati in 1849. By 1998 Dun & Bradstreet had amassed a database of information on 40 million businesses worldwide including 10 million businesses in the United States. By 1998 Dun & Bradstreet had 64,000 subscription customers and 175,000 non-subscription customers in the United States.

The Business Credit Reporting Service of the National Association of Credit Management (NACM) is another important player in commercial credit reporting. NACM was launched in 1896 to deal with a number of growing financial problems relating to commercial credit. These problems included fraud, misrepresentations, absence of a uniform federal bankruptcy law, and an ever-increasing demand for credit. Today the NACM is a member-owned organization dedicated to supporting the growth of the credit and finance community and representing business credit grantors in most industries including manufacturing, wholesaling, and the financial and service sector.

Another well-known name in American credit rating circles is Moody's Investor Service. Moody's traces its beginnings to 1909 when John Moody first published the Moody's Manual of Industrial and Corporation Securities. Also in 1909 Moody introduced his bond rating system which is still in use today and emulated by similar institutions. Moody based his ratings on public information and the ratings were assigned without the request of the bond issuers. Like Dun & Bradstreet, of which Moody's is now a part, Moody's helps investors manage credit risk.

There are two kinds of commercial credit reporting agencies—general and special. Special agencies collect credit-related information on only a special type of activity such as bond offerings. General agencies deal with a broader spectrum of business activities and issue general and special reports. The general reports are comprehensive and are issued in credit reporting books which are published quarterly. These books are leased to subscribers and contain information on a multitude of companies and financial institutions. The Dun & Bradstreet Reference Book, for instance, contains more than 3 million company names, each with its own capital and credit rating. The information contained on each company comes from its financial statement which Dun & Bradstreet updates on a semiannual basis.

Special reports are limited to a specific company or institution and are generally provided to agency customers on an individual contractual basis. Special reports generally encompass a wide range of data including but not limited to: history of the company, past business record, personnel, nature of business, latest financial statement, assets and liabilities, court and legal proceedings, general credit standing, and business outlook. Information found in both general and special reports comes from a variety of sources, including direct investigation, trade creditors and banks, public records, and insurance records.

Commercial credit reporting agencies employ agents or correspondents (now often called reporters) who gather information from the above mentioned sources. They also mail out semiannual questionnaires to the companies and institutions that the agencies maintain files on. Businesses are generally quite cooperative as they recognize the importance of their credit standing in the business community. Information taken from public records can be forwarded to the collecting agency by the county clerk if the company is located in a small community. In large cities and metropolitan areas the collecting agency sends in their own employees to scour and copy information from public records. Public records can reveal litigation and other court proceedings such as bankruptcy, liens, and mortgage incumberances.

There are a number of commercial credit rating agencies that specialize in the evaluation of bond offerings. The best known is Moody's Investors Service but other bond rating agencies include Standard & Poor's, Fitch, and Duff & Phelps. Bond ratings are especially important to investors because bonds, unlike stocks, are debt securities. Stocks are equity securities which means every stockholder in a company owns part of that company. A bond represents a loan made by the buyer to the issuing company. Bonds are thus backed by the "full faith and credit" of the issuer and not by equity in the company. Bonds are also fixed-income securities which pay a predetermined amount of interest over a predetermined period (long-term bonds generally reach maturity in 20 to 30 years; intermediate or medium term bonds generally reach maturity in 5 to 10 years.) The rate of interest that a corporate bond pays is related to the risk that the purchaser is willing to tolerate. A low rating means higher risk and a higher interest rate necessary to attract buyers. Conversely the higher a bond's rating the lower the interest it must pay to attract buyers. Often the issuer of a bond offering will pay a rating agency for this evaluation.

All of the bond rating agencies have a similar alphabetical rating system consisting of a series of uppercase and lower letters A thru D. For instance, the highest or safest rating Moody's gives a bond is Aaa while the other three assign an AAA to their highest rating. Moody's other ratings are as follows: Aa—very fine quality; A—strong capacity to pay; Baa—adequate ability to pay, lowest investment grade for banks; Ba—somewhat speculative, risk exposure; B—more speculative, risk exposure; Caa—major risk exposure, Ca—crucial risk exposure; C—default on interest payments; D—general default; and NR—no rating has been requested. The other agencies do not use lower case letters but otherwise their rating schemes are quite similar. Bond issuers can also be put on a credit watch if a rating agency is thinking of downgrading or upgrading their bonds. Occasionally A rated bonds are given a + or a—to indicate a strong or weak A rating. Standard & Poor's will sometimes attach an "r" to the rating which means that the bonds return can undergo "dramatic fluctuations" even while the bond maintains a strong credit rating. Bonds can of course be bought and sold many times on the secondary market before they reach maturity. Throughout the course of a bond's life, agencies can change its rating depending on the changing ability of the issuer to meet the bond's obligations. The general health of the industry of which the bond is part can also affect the bond's rating beyond the health of the individual company that issued the bond.

Besides rating corporate bonds, agencies also evaluate municipal bonds and commercial paper. Municipal bonds are issued by state and local governments and their interest is exempt from federal income tax. Interest from municipal bonds is also exempt from city and state taxes if the bond's buyer lives within their respective jurisdictions. Commercial paper is an unsecured short-term promissory note (generally I to 270 days) for large sums of money, usually over $100,000. The issuer sells the paper at a discount from its face value. The difference between the discount and the payoff represents the interest or return. Commercial paper is often rolled over or sold commercially rather than being paid off. Bonds, and to a lesser extent commercial paper, are a very important source of money for corporations and local and state governments. The risk analysis that agencies provide potential bond customers is a vital link between the issuer and purchaser. Bond rating agencies thus provide a stable environment in which buyer and issuer can come together. Much care goes into determining a bond's rating as a shift from one rating to another can represent as much as 1 percent jump in the interest rate that must be paid to attract buyers.