Credit Rating Agencies

Regulation proposals show signs of positive action

Originally published in the December 2008/January 2009 issue

Credit Rating Agencies (CRAs) have come in for criticism over the past 12 months for the role that it is said they have played in the collapse of the financial markets. This has led to the call for better regulation of their activities. To this end, in the US, the Securities and Exchange Commission (SEC) first issued ‘Proposed Rules for Nationally Recognised Statistical Rating Organizations’ on 16 June 2008 (the SEC Proposals) and, on 12 November 2008, the EU followed by adopting a ‘Proposal for a Regulation of the European Parliament and the Council on Credit Rating Agencies’ (the EU Proposals). Both the SEC and EU proposals provide extensive justification of the reasons why better regulation is thought necessary. The aim of this article is to disseminate and analyse the important proposals arising in each jurisdiction.

SEC proposals – principal issues
The US model for better regulation has occurred in two stages. Legislation came into force, in June 2007, which provided for SEC registration of CRAs, and gave the SEC authority to implement financial reporting, oversight and recordkeeping requirements for CRAs.In broad summary, current laws and regulatory rules exist in the US which require CRAs to make public disclosures, make and retain records, furnish financial reports to the SEC, manage the handling of material non-public information and disclose and manage conflicts of interest. The SEC Proposals seek to introduce further rules to increase the transparency in the rating process and introduce further prescriptive steps to avoid conflicts of interests arising. The key aspects of the SEC proposals are summarised as follows:

• CRAs to be prohibited from: issuing ratings on structured products without information on the characteristics of the underlying assets being made available; issuing a rating on a product where that CRA has made recommendations as to its structuring; and involving individual analysts in fee negotiations with issuers.

• CRAs to be required to: publicise all their ratings and subsequent monitoring actions; publish performance statistics for one, three and ten years; give disclosure of information about reliance on verification of the underlying assets in a product in determining ratings; disclose how frequently ratings are reviewed, whether different rating models are used to review than were used to issue and whether any changes to rating models are applied to existing ratings; make annual reports of the number of ratings issued and reviewed; and differentiate ratings issued on structured products from other securities.

EU proposals – principal issues
Four possible options were considered by the EU for the better regulation of CRAs. These options were: maintaining the status quo (i.e. self regulation), introducing a code of conduct and monitoring body with no enforcement powers, issuing a non-binding recommendation or introducing legislation for the registration and surveillance of CRAs.

The EU Proposals adopt the legislative approach. This was the only approach that provided effective means of enforcement, a common framework throughout the EU and “an efficient counterbalance to other important jurisdictions, notably the US.” The key features of the EU proposals are as follows:

• The introduction of a binding registration and surveillance regime for CRAs issuing ratings for use for regulatory purposes by credit institutions, investment firms, insurance, assurance and reinsurance undertakings, collective investment schemes and pension funds (Rating Users).

• Rating Users may only use ratings issued by CRAs established in the EU and registered in accordance with the regulations.

• CRAs to ensure that ratings issued are not affected by existing or potential conflicts of interest.

• Individual analysts are prohibited from being involved in fee negotiations with issuers,they must not be involved in rating the same entity or its products for a period exceeding four years (with a rotation system being established) and may not re-commence rating that agency/its products within a two year period, and they may not be paid contingent on the amount of revenue the CRA derives from its ratings of the entity or its products which the analyst rates.

• CRAs must publicly disclose rating methodologies; ratings must be based on an analysis of all information available that is of relevance to methodologies; they must monitor and review ratings issued; and, when they change methodologies, the CRA must immediately disclose the scope of the credit ratings affected, review those ratings as soon as possible and not later than within six months, and re-rate all ratings based on the previous methodologies.

• CRAs must disclose ratings on a non-selective basis and in a timely manner. They must also disclose policies and procedures regarding unsolicited ratings.

• CRAs are required to disclose, and update immediately, information about conflicts of interest, ancillary services, policy concerning publication of ratings, staff compensation arrangements, methodologies and material changes and any material modification to practices, procedures and processes. CRAs must give, every six months, disclosure of data about historical default rates of rating categories and any changes. The CRAs must give annual disclosure of their largest 20 clients by revenue.

• CRAs must publish annual ‘transparency’ reports which give details of legal structure and ownership, internal quality control systems, statistics on staff allocation to new ratings, rating reviews, methodology appraisal and management, ratings record keeping policies, annual independence compliance reports, management and rotation of analysts and financial information on revenue of rating and non-rating services.

• The Committee of European Securities Regulators (CESR) is empowered as the over-arching authority responsible for the regulation of CRAs. However, sanctioning and enforcement is left to be carried out by the local regulators in each member state. Significantly, it is left to the local regulators to decide the measure of sanctions.

• The local regulators are also specifically empowered under Article 29 to enter into co-operation agreements on exchange of information with regulators in jurisdictions outside the EU.

The EU Proposals have some way to go before they become law. The next step is for consideration by the European Parliament and Council. They will then be published in the Journal of the European Union and will come into force six months after the date of publication.

The legislative measures have been criticised for being too little too late and overly prescriptive. The common approach being adopted for the better regulation of the CRAs in the EU and the US is both encouraging and to be encouraged. A lot of it will come as no great upheaval to CRAs as it is largely based on existing self regulatory measures. However, the proposals do serve as evidence of the legislature taking positive action now whilst looking ahead to seek to prevent the same issues arising in the future which have contributed to the financial turmoil this time around. It is not though, on its own, a step that will bring stability back to the markets.


Jonathan Brogden is a Partner in Davies Arnold Cooper LLP’s Dispute Resolution Group. He specialises in disputes arising in financial markets and commerce.