Amlie Champsaur

THE REGULATION OF CREDIT RATING AGENCIES IN THE U.S. AND THE E.U.: RECENT INITATIVES AND PROPOSALS

Seminar in International Finance LL.M. Paper Under the Supervision of Professor Howell E. Jackson

Harvard Law School May 2005

Amlie Champsaur

Contents

I.

The credit rating business...8 A. The credit rating market...8 B. The credit rating process11 C. The credit rating business model...14

II. A. B. C.

The multiple values of credit ratings18 The informational value of credit ratings...19 The transactional value of credit ratings22 The regulatory value of credit ratings24

III.

Reliance without reliability? Justifying regulatory intervention..29

A. B.

Are credit ratings reliable?.29 Regardless of reliability, reliance itself creates systemic risk...33

IV.

The CRA regulation options36

A. B. C.

Regulating credit ratings37 Regulating CRA activities: establishing conduct of business rules...39 Enforcing conduct of business rules..41

Conclusion..46 Annex A: IOSCO Code of Conduct

Amlie Champsaur In the past three years, regulators and legislative bodies in the U.S. and the E.U. have taken various initiatives to examine the activities of credit rating agencies (CRAs), question the reliability of credit ratings and whether regulators should use them, and generally ask whether it is reasonable for CRAs to be very lightly or not regulated in most jurisdictions. These initiatives have been prompted by accounting scandals such as Enron, Worldcom and Parmalat, companies that were still rated investment grade a few days before they filed for bankruptcy. The first reaction was that of the U.S. Congress, who held hearings in order to investigate the reasons for CRAs general lack of anticipation of the Enron collapse.1 The Congress staff report pointed to certain CRA shortcomings, in particular (i) a lack of diligence in the coverage of Enron (such as CRAs taking what management told them for granted and not seeking to verify accounting and other information) and (ii) a general lack of accountability mechanisms, due to little regulatory exemptions and First Amendment protections.2 A few months later, as required by Section 702 of the Sarbanes Oxley Act of 20023, the SEC issued a Report on the Role and Function of Credit Rating Agencies in

Rating the raters, Enron and the Credit Rating Agencies, Hearings before the Senate Committee on Governmental Affairs, 107th Congress (March 2002) 2 Report of the Staff of the Senate Committee on Governmental Affairs: Financial Oversight of Enron: the SEC and Private Sector Watchdogs, S. Prt. 107-75 (October 7, 2002) 3 Section 702 of the Sarbanes-Oxley Act provides: Sec. 702. Commission study and report regarding credit rating agencies. (a) Study required. (1) In general. The Commission shall conduct a study of the role and function of credit rating agencies in the operation of the securities market. (2) Areas of consideration. The study required by this subsection shall examine (A) the role of credit rating agencies in the evaluation of issuers of securities; (B) the importance of that role to investors and the functioning of the securities markets; (C) any impediments to the accurate appraisal by credit rating agencies of the financial resources and risks of issuers of securities; (D) any barriers to entry into the business of acting as a credit rating agency, and any measures needed to remove such barriers;

Amlie Champsaur the Operation of the Securities Markets (the SEC Report), addressing certain structural dysfunctions in the CRA market and business model.4 A review of CRAs was already underway at the SEC5, given the wide use for regulatory purposes, under federal securities laws, of credit ratings issued by CRAs designated by the SEC as Nationally Recognized Statistical Rating Organizations (NRSROs). In June 2003, the SEC issued a concept release seeking comments with respect to (i) whether credit ratings should continue to be used for regulatory purposes, and in the affirmative, whether the NRSRO certification procedure was appropriate and (ii) more generally, what should be the adequate level of CRA regulatory oversight.6 On April 19, 2005, the SEC released a Proposed Rule aiming at ensuring a higher level of transparency with respect to the NRSRO concept.7

(E) any measures which may be required to improve the dissemination of information concerning such resources and risks when credit rating agencies announce credit ratings; and (F) any conflicts of interests in the operation of credit rating agencies and measures to prevent such conflicts or amelioratethe consequences of such conflicts. 4 ((http://www.sec.gov/news/studies/credratingreport0103.pdf) The main issues identified by the SEC Report were the following: - Information flow (disclosure of information by CRAs and issuers) - Potential conflicts of interest in connection with CRA issuers and subscribers - Alleged anticompetitive or unfair practices - Potential regulatory barriers to entry on the CRA market - Ongoing oversight of CRAs 5 On March 19, 2002, the SEC issued an Order In the Matter of the Role of Rating Agencies in the U.S. Securities Markets Directing Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934, and Designating Officers for such Investigation (March 19, 2002). The purpose of the Order was to ascertain facts, conditions, practices and other matters relating to the role of credit rating agencies in the U.S. securities markets, and to aid the Commission in assessing whether to continue to use credit ratings in its rules and regulations under the federal securities laws and, if so, the categories of acceptable credit ratings and the appropriate level of regulatory oversight (SEC Proposed Rule, p. 13). CRA hearings were also held, on November 15 and 21, 2002. 6 Securities and Exchange Commission, Concept Release: Rating Agencies and the Use of Credit Ratings under Securities Laws, Release Nos. 33-8236; 34-47972; IC-26066 (http://www.sec.gov/rules/concept/338236.htm) (the Concept Release). The Concept Release sought comments on: (i) possible alternatives to the current NRSRO designation, (ii) criteria used to recognize CRAs as NRSROs, (iii) examination and oversight of CRAs, (iv) conflicts of interest, and (v) alleged anticompetitive, abusive and unfair practices. 7 Securities and Exchange Commission, Proposed Rule: Definition of Nationally Recognized Statistical Rating Organization, 17 CFR Part 240, Release Nos 33-8570; 34-51572; IC-26834 (http://www.sec.gov/rules/proposed/33-8570.pdf/) (the Proposed Rule). The proposed definition contains three components that must each be met in order for a CRA to be an NRSRO: an NRSRO is an entity (i)

Amlie Champsaur In parallel to SEC initiatives, the technical committee of IOSCO prepared a Report on the Activities of Credit Ratings Agencies8, followed by a Statement of Principles Regarding the Activities of Credit Rating Agencies, which were issued in September 2003.9 This set of high-level objectives is based on the premise that CRAs play a valuable role in global securities markets, since market participants and regulators tend to greatly rely on credit ratings, and that CRA activities should thus be conducted in a way that ensures greater credit rating reliability. In December 2004, IOSCO published its Code of Conduct Fundamentals for Credit Rating Agencies (the IOSCO Code).10 The IOSCO Code focuses on corporate governance rules designed to guarantee that CRAs (i) ensure quality and integrity of the rating process, (ii) remain independent and avoid conflicts of interest, (iii) assume their responsibility to market participants through greater methodology transparency and adequate treatment of confidential information provided by issuers. However, IOSCO does not address the issue of how to enforce the Code: it recommends that CRAs adopt these rules as part of their individual code of conduct and leaves enforcement to either national regulators or market mechanisms.11

that issues publicly available credit ratings that are current assessments of the creditworthiness of obligors with respect to specific securities or money market instruments; (ii) is generally accepted in the financial markets as an issuer of credible and reliable ratings, including ratings for a particular industry or geographic segment, by the predominant users of securities ratings; and (iii) uses systematic procedures designed to ensure credible and reliable ratings, manage potential conflicts of interest, and prevent the misuse of non-public information and has sufficient financial resources to ensure compliance with those procedures. 8 http://www.iosco.org/pubdocs/pdf/IOSCOPD153.pdf 9 http://www.iosco.org/pubdocs/pdf/IOSCOPD151.pdf 10 http://www.iosco.org/pubdocs/pdf/IOSCOPD180.pdf 11 Further, the CRA Code Fundamentals are not designed to be rigid or formulistic. They are designed to offer CRAs a degree of flexibility in how these measures are incorporated into the individual codes of conduct of the CRAs themselves, according to each CRAs specific legal and market circumstances. However, in developing their own codes of conduct, CRAs should keep in mind that securities regulators may decide to incorporate the CRA Code Fundamentals into their own regulatory oversight, may decide to supervise compliance with the CRA Code Fundamentals, and/or may decide to provide for an outside arbitration body to enforce the CRA Code Fundamentals. Jurisdictions may also rely on market mechanisms to enforce compliance with the CRA Code Fundamentals, as the market may judge a CRA

Amlie Champsaur In the E.U., the Enron collapse prompted discussions on CRA reliability at the Oviedo ECOFIN meeting in April 2002 and at European Securities Committee meetings in May and September 2003. In February 2004, even before the failure of all major CRAs to anticipate the Parmalat collapse, the E.U. Parliament passed a resolution calling on the E.U. Commission to submit by July 31, 2005 its assessment of whether and how CRAs should be regulated, and in particular, of the need for legislative measures.12 The Commission called on CESR for advice on this matter.13 CESR released a consultation paper in November 2004 (the Consultation Paper)14 and issued its final advice to the Commission on March 30, 2005 (the Technical Advice).15 Despite the E.U. Parliaments initial preference for pervasive regulation. the Technical Advice recommends a non-legislative solution, based on CRA self-regulation through the adoption of individual codes of conduct based on the IOSCO Code.16

adversely if its own code of conduct fails to address the provisions contained in the CRA Code Fundamentals (IOSCO Code, p.2) 12 E.U. Parliament Committee on Economic and Monetary Affairs, Rapporteur G. Katiforis, Report on Role and Methods of Credit Rating Agencies, A5-0040/2004 (January 29, 2004) (the E.U. Parliament Report) (http://www2.europarl.eu.int/omk/sipade2?PUBREF=-//EP//NONSGML+REPORT+A5-20040040+0+DOC+PDF+V0//EN&L=EN&LEVEL=3&NAV=S&LSTDOC=Y) 13 The four core issues identified by the E.U. Commission were: (i) potential conflicts of interests within CRAs, (ii) transparency of CRAs methodologies, (iii) legal treatment of CRAs access to inside information, (iv) concerns about possible lack of competition in the market for provision of credit ratings 14 CESRs Technical Advice to the European Commission on Possible Measures Concerning Credit Rating Agencies: Consultation Paper, CESR 04-612b (November 2004) 15 CESRs Technical Advice to the European Commission on Possible Measures Concerning Credit Rating Agencies, CESR 05-139b (March 2005) 16 In a speech given in Amsterdam on September 17, 2004 (The Global Marketplace and a Regulatory Overview), Commissioner Roel C. Campos of the SEC, who also leads the Chairmans taskforce of the technical committee of IOSCO, said that Neither the US nor many member states have taken additional steps in the regulation of rating agencies, meaning that convergence of national approaches to credit rating agencies is not only possible, but should be encouraged. In fact, the IOSCO Technical Committee reconstituted its credit rating task force this spring to develop an international code of conduct that will assist rating agencies and regulators in putting the IOSCO credit rating agency principles into effect. The code offers a set of practical measure that will serve as a guide to help implement the Principles' objectives and promote a converged standard for credit rating conduct throughout the world. The code is currently being discussed within IOSCO and with industry and will be presented to the member regulators for finalization this winter (http://www.sec.gov/news/speech/spch091704rcc.htm). This statement advocating the implementation of the IOSCO Code throughout the world might have been in reaction to the E.U. Parliaments initial strong stance in favor of a registration of CRAs in the E.U. (see E.U. Parliament

Amlie Champsaur In contrast to the securities regulators seemingly growing distrust of CRAs, manifested by the quasi-simultaneous IOSCO, SEC and CESR consultations, banking regulators seems to encourage further reliance of the banking sector on credit ratings, regardless of CRA regulation. In June 1999, the Basel Committee proposed a revised capital adequacy accord, finalized in June 2004 (the Basel II Agreement), which provides that banks have the option of relying on ratings provided by CRAs to assess counterparty credit risk, for the purpose of calculating their capital requirements.17 The implementation of the Basel II Agreement is underway in the E.U., in the form of the Capital Requirement Directive (the CRD).18 The securities regulators reaction to certain CRA shortcomings and structural dysfunctions, on the one hand, and the increased reliance of the banking industry on credit ratings, on the other hand, appear to be contradictory trends, but both seem to compel increased oversight of CRAs and tighter regulation of CRA activities. Paradoxically, the consensus emerging from the above-mentioned consultations is that CRA self-regulation and an increased level of disclosure appear to be the best ways to
Report: Rating agencies active in Europe should be asked to register with a European Union Ratings Authority, to be specifically set up for the purpose, in the context of CESR. Registration with a European authority would help redress the imbalance between Europe and the U.S. while not forcing the agencies to confront fifteen or twenty-five different national European regulatory authorities and separate jurisdictions. Registration would imply accountability, implemented by periodic reporting to the European ratings authority and supervision over the conditions of effectiveness of rating activity, implemented by an active dialogue between the management of the agencies and the regulator) 17 International Convergence of Capital Measurement and Capital Standards, A Revised Framework (June 2004) (http://www.bis.org/publ/bcbs107.pdf.) The Committee proposes to permit banks a choice between two broad methodologies for calculating their capital requirements for credit risk. One alternative will be to measure credit risk in a standardized manner, supported by external credit assessments. The alternative methodology, which is subject to the explicit approval of the banks supervisor, would allow banks to use their internal rating systems for credit risk(50). National supervisors are responsible for determining whether an external credit assessment institution (ECAI) meets the criteria listed in the paragraph below. The assessment of ECAIs may be recognized on a limited basis, e.g. by type of claims or by jurisdiction. The supervisory process for recognizing ECAIs should be made public to avoid unnecessary barriers to entry (90). The eligibility criteria for ECAIs are: objectivity, independence, international access/transparency, disclosure (of methodologies and actual default rates), resources, and credibility (91). 18 The CRD proposal was adopted by the E.U. Commission on July 14, 2004 (http://europa.eu.int/comm/internal_market/bank/regcapital/index_en.htm#capitalrequireproposal)

Amlie Champsaur ensure better credit rating reliability. Indeed, market participants responses to the SEC Concept Release, the IOSCO Code and the CESR Consultation Paper indicate a quasiunanimous refusal of legislative and/or regulatory solutions.19 In this paper, I will explain the policy considerations that underlie the ongoing discussions with respect to CRAs regulation, and why these policy considerations, as well as CRAs particular business model and market structure justify that, despite evidence of strong market and regulatory reliance on credit ratings in the securities and banking industries, no pervasive legislative and/or regulatory steps will be taken in the near future to oversee CRAs. Part I describes the credit rating industry and business model. Part II explains the increasing reliance of various market participants on credit ratings. Part III justifies the policy of ensuring credit rating reliability. Part IV describes the CRA regulation dilemmas and explains why CRA self-regulation and greater disclosure might be the solution to this dilemma.

I.

The credit rating business

A. The credit rating market

CRAs are privately owned companies that engage in the business of rating issuers and debt instruments. The market structure for CRAs is generally considered as not being highly competitive: it is dominated by 3 major rating agencies acting
19

Comments received by the SEC on the Concept Release are available at http://www.sec.gov/rules/concept/s71203.shtml; Comments received by CESR are available on http://www.cesr-eu.org/

Amlie Champsaur worldwide (Standard & Poors, Moodys and Fitchratings), although there are smaller, regional and/or specialized agencies.20 The CRA market is generally considered as having high natural barriers to entry, due to the fact that CRAs require highly qualified analysts, as well as high tech rating methodologies, some of which are proprietary.21 Moreover, credibility is an essential asset of CRAs, which creates a further barrier to entry, since reputation takes time to achieve.
22

There are concerns that the fact that

regulators use the credibility criteria in order to recognize CRAs for regulatory purposes may further increase the dominant position of the established CRAs and thus potentially diminish credit rating quality, since smaller, recently created or foreign CRAs that might produce objectively reliable ratings obviously have greater difficulty to fulfill it.23 This is particularly true in the U.S., with the NRSRO designation system, which is

20

For a general discussion on CRA market and history, see Claire A. Hill, Regulating the Rating Agencies, 82 Wash. U.L.Q. 43 (2004): Even before the regulations providing for NRSRO designation came into existence, there were never a large number of non-specialist rating agencies () Moodys and Standard & Poors have a combined market share in excess of 80%, while Fitchs market share is approximately 14%. Aside from Fitch, there are a number of other rating agencies, both general purpose and specialized, but, as the above numbers suggest, they are quite small relative to Moodys and Standard & Poors. See also Amy K. Rhodes, The Role of the SEC in the Regulation of the Rating Agencies: Well-Placed Reliance or Free-Market Interference?, 20 Seton Hall Legis. J. 293 (1996). 21 SEC Report: Hearing participants recognized that limited competition exists today in the credit rating industry and, in general, were of the view that additional competition would have a beneficial effect on the marketplace. Some noted that, historically, successful new entrants often established themselves by first specializing in a particular industry. There was less consensus on the reasons for the concentration in the credit ratings business today. Some believed natural barriers to entry exist, given the substantial investment and track record necessary to achieve marketplace acceptance of ratings. See also Basel Committee on Banking Supervision, Credit Ratings and Complementary Sources of Credit Quality Information, Working Papers No. 3 (2000). 22 CESR Technical Advice: New CRAs face a number of natural barriers to entry (). The very nature of the CRA market might make it difficult for new CRAs to succeed. Issuers usually only desire ratings from those CRAs that are respected by investors. However, investors might tend to respect only those CRAs that are respected by investors. However, investors might tend to respect only those CRAs with a history of accurate and timely credit ratings. Investors could be reluctant to accord the ratings of a new entrant the same regard as those of established CRAs because new entrants lack historical default rates by which investors can compare performance to that of other CRAs. As a result, issuers may be reluctant to engage a new entrant for a rating. Without investor or issuer interest, it may take considerable time for a CRAs rating business to become self-sustaining 23 Claire A. Hill, Rating Agencies Behaving Badly, 35 Conn. L. Rev. 1145 (2003): Historically, obtaining the NRSRO designation has been very difficult, with candidates describing themselves as caught in a

Amlie Champsaur based on the requirement that a CRA be nationally recognized, arguably protecting the U.S. national market and strengthening its oligopolistic structure.24 () Government should consider balancing the need for a rigorous standard for NRSRO designation against the need to ensure that a sufficient number or rating agencies receive NRSRO designation to assure competition.25 Accordingly, one the main stated benefits of the SECs Proposed Rule clarifying NRSRO designation process is to facilitate the entry of new CRAs on the market, thereby enhancing market mechanisms which make selfregulation a sustainable option. 26 In its Technical Advice however, CESR notes that the impact of regulatory requirements on competition is not clear and therefore does not recommend the use of regulatory requirements as a measure to reduce or remove entry barriers to the market for credit ratings.27

Catch-22: they cant get the designation unless they are nationally recognized, and they cant be nationally recognized until they get the designation. 24 SEC Proposed Rule (p. 52): () The notion that a credit rating agency be nationally recognized for purposes of the NRSRO concept was designed to ensure that credit ratings used for regulatory purposes are credible and reliable, and are reasonably relied upon by the marketplace. The SEC mentions that in 1998, the U.S. Department of Justice opposed the use of the national recognition requirement because, in its view, that criterion likely creates a nearly insurmountable barrier to new entry into the market for NRSRO services(Comments on the U.S. Department of Justice in the Matter of: File No. S7-33-97 Proposed Amendments to Rule 15c3-1 under the Securities Exchange Act of 1934 (March 6, 1998)). DOJ believed that, while the historical dominance of Moodys and S&P had eroded in recent years for certain types of securities ratings, the overall level of market power they retained continued to be a competitive concern 25 Steven L. Schwarcz, The Role of Rating Agencies in Global Market Regulation, in Regulating financial services and markets in the 21st century / ed. Eils Ferran and Charles A.E. Goodhart. Oxford; Portland, Or. Hart Pub. (2001) 26 The Proposed rule would provide greater clarity to determine whether credit rating agencies are NRSROs. () For credit rating agencies that are not currently NRSROs, the definition would provide a better understanding of the enhancements necessary to meet the definition. This could reduce concerns related to barriers to entry (). Moreover, concerns about barriers to entry also could be reduced by the interpretations of the proposed definition that would recognize credit rating agencies with an expertise in a particular industry or geographic region. () By lowering the barriers to entry identified above, the proposed rule could potentially increase the number of NRSROs. Issuers would be provided with more choice in terms of selecting NRSROs to rate their debt securities, which could lower their costs for this service. The greater competition in the market for credit ratings and analysis could provide for more credible and reliable ratings. Greater competition also could stimulate innovation in the technology and methods of analysis for issuing credit ratings, which could further lower barriers to entry. (SEC Proposed Rule, p. 60-61) 27 A significant number of respondents expressed the desire fore regulators to carefully avoid increasing barriers to entry, stating that any statutory/unduly prescriptive regulation could increase barriers. The small

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Amlie Champsaur

B. The credit rating process

A credit rating is generally defined as an opinion forecasting the creditworthiness of an entity, a credit commitment, a debt or debt-like security or an issuer of such obligations, expressed using an established and defined ranking system. Credit ratings are not recommendations to purchase or sell any security.28 Creditworthiness is the likelihood that an issuer will make timely payments on a particular debt or debt-like security or, in the case of an issuer rating, on its financial obligations generally.29 Credit ratings come in the synthetic form of letters, which are either investment grade or speculative (or junk), short term or long term, and are subdivided into more detailed credit risk categories, which are not homogenized among CRAs.30

CRAs had an opposite view, as they think that a regulatory mechanism with a clear set of criteria that CRAs would follow could have a positive effect on competition (CESR Technical Advice, n. 251) 28 The Commission Directive 2003/125 on the fair presentation of investment recommendations and the disclosure of conflicts of interest states that: Credit rating agencies issue opinions on the credit worthiness of a particular issuer or financial instrument as of a given date. As such these opinions do not constitute a recommendation within the meaning of this directive. However, credit rating agencies should consider adopting internal policies and procedures designed to ensure that credit ratings published by them are fairly presented and that they appropriately disclose any significant interests or conflicts of interest concerning the financial instruments or the issuers to which their credit ratings relate. The SEC Report defines a credit rating as reflecting a CRAs opinion, as of a specific date, of the creditworthiness of a particular company, security or obligation. 29 The IOSCO Report further clarifies that an assessment of an issuers or a debt instruments creditworthiness is not equivalent to an assessment of its value, thus a credit rating does not provide an opinion on the value of an issuers equity securities. 30 For a description of credit risk categories and rating scales and symbols used by CRAs, see Amy K. Rhodes, The Role of the SEC in the Regulation of the Rating Agencies: Well-Placed Reliance or FreeMarket Interference?, 20 Seton Hall Legis. J. 293 (1996). Most CRAs have progressively refined the rating scales to include market risk and interest rate risk, although the main assessment provided by ratings is primarily credit risk. The SEC has indicated that it did not intend to standardize rating symbols. One reason is that mandated uniformity of rating symbols could mislead investors into assuming that all NRSRO credit ratings are comparable and involve the same analytical judgments, ratings criteria and methodologies (Proposed Rule, p. 49).

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Amlie Champsaur In order to arrive at a particular credit rating, CRAs analyze public financial, accounting and other information about the issuer, as well as current and prospective macro economical and market factors that may affect the issuers or the debt instruments credit risk, which is composed of both financial risk (financial policy, profitability, liquidity and debt management) and industrial/commercial risk (sector risk, competitive position, strategy, industrial and restructuring projects, etc).31 In most cases, the CRAs communicate with the issuers management and thus also base their ratings on non-public information.32 However, CRAs do not verify the accuracy of accounting, financial or other information and are not liable under securities laws for failing to reasonably question the truthfulness and non misleading character of such information. In particular, CRAs are exempted from liability under Section 11 of the Securities Act of 1933.33 The SEC has proposed however that CRAs have controls in place to reasonably assess the integrity of the information sources they rely on in their ratings process, noting

AMF Report, p.48. For a description of the rating process, see also Amy K. Rhodes, The Role of the SEC in the Regulation of the Rating Agencies: Well-Placed Reliance or Free-Market Interference?, 20 Seton Hall Legis. J. 293 (1996). 32 Certain CRAs also issue unsolicited credit ratings, i.e. based exclusively on public information and without issuer cooperation. In this case the issuer is not billed for the rating service. The 2004 AMF Report on Credit Rating Agencies, issued in January 2005 by the French securities regulator (AMF) (hereinafter the AMF Report, http://www.amf-france.org/documents/general/5891_1.pdf), p. 16, indicates that this practice has steadily decreased in the past years. However, two of the main CRAs (Standard & Poors and Fitch) have indicated that they would not completely discontinue it. In addition, these CRAs indicated that they do practice CRA initiative rating assessments, whereby CRAs are the ones initiating the rating, but where the issuer fully cooperates and thus provides them with non public information, in order not to obtain an unfavorable rating. This service is not billed to the issuer. In its Proposed Rule, the SEC indicates that unsolicited ratings raise sufficient concerns such that a credit rating agency should have procedures designed to avoid employing improper practices with respect to unsolicited ratings and to monitor and verify compliance with those procedures. The IOSCO Code indicates that the CRA should disclose when its ratings are not initiated at the request of the issuer and whether the issuer participated in the rating process (3.8). 33 Steven L. Schwarcz, Private Ordering of Public Markets: the Rating Agency Paradox, U. Ill. L. Rev. 1 (2002): Because rating agencies make their rating determinations based primarily on information provided by the issuer of securities, a rating is no more reliable than that information. Ratings thus do not cover the risk of fraud.

31

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Amlie Champsaur that this was not to suggest that CRAs should auditor otherwise ensure the accuracy of an issuers financial condition.34 Each CRA uses its own credit risk assessment methodology, which is usually made public on its website, where the CRA explains the quantitative and qualitative factors used to determine credit ratings for each category of debt (depending on the economic sector, whether the issuer is a sovereign, municipal or corporate entity, the type of debt instrument or structured finance vehicles, etc). However, CRAs generally indicate that although the same global methodology is used when issuers are of the same type or belong to the same sector, the weighting of different factors may vary according to the issuer or the debt instrument, on a case by case basis, due to the particular characteristics of the issuer or to the particular impact on the issuer of certain financial, economic, political or other factors.35 Moreover, the appreciation of certain factors taken into account in the rating process is essentially subjective;36 thus, the publication of a CRAs methodology may helps the issuer and investors better understand the rating process, but is not in sufficient to predict the CRAs opinion on a particular issuers or debt instruments itself credit risk.37 Accordingly CRAs do not have a legal duty of accuracy and are protected from liability in the U.S. by the First Amendment.38

SEC Proposed Rule, p. 39. See for instance Standard & Poors rating criteria at http://www2.standardandpoors.com/servlet/Satellite?pagename=sp/Page/FixedIncomeRatingsCriteriaPg&r =1&l=EN&b=2&s=21&ig=2&ft=24 36 See Basel Committee on Banking Supervision, Credit Ratings and Complementary Sources of Credit Quality Information, Working Papers No. 3 (2000). 37 AMF report (p. 49). This is the reason why investors subscribe to detailed CRA reports and need to contact CRAs regularly to obtain further explanations on how a particular rating was reached. CRAs publish only ratings and general methodologies. 38 Claire A. Hill, Regulating the Rating Agencies, 82 Wash. U.L.Q. 43 (2004), noting that the current regulatory regime doesnt scrutinize rating agency performance with a view toward imposing penalties for bad performance. Neither, it seems do the courts. Ratings are deemed opinions and thus protected speech. See Jefferson County Sch. Dist. V. Moodys Investors Servs., Inc., 988 F. Supp. 1341, 1348 (D. Colo. 1997), affd, 175 F.3d 848 (10th Cir. 1999). For a discussion of First Amendment issues, see also
35

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C. The credit rating business model

CRAs are issued pursuant to contractual terms set forth in an agreement between the issuer and the CRA. The issuers incentive to purchases credit ratings from CRAs is the need to signal its creditworthiness and generally its sound financial condition to lenders and investors and thus reduce its cost of capital.39 Accordingly, credit ratings are generally issued at the request of issuers, who are the ones paying for the rating service.40 This creates potential conflicts of interest, insofar as issuers may be tempted to pressure the CRA into issuing a higher rating. CRAs have however generally taken steps to prevent such conflicts, by either disclosing them, ensuring that they are independent as regards their ownership structure and not letting any single issuer account for more of a certain percentage of their revenue.41 The IOSCO Code deals with these issues in

Francis A. Bottini, Jr, An Examination of the Current Status of Rating Agencies and Proposals for Limited Oversight of Such Agencies, 30 San Diego L. Rev. 579. 39 Claire A. Hill, Regulating the Rating Agencies, 82 Wash. U.L.Q. 43 (2004): Ratings also provide information in the form of a signal as to the debt issuers own views about the issue for which it is obtaining a rating. () An issuer typically gets ratings from both Moodys and Standard & Poors. In abiding by the two-ratings norm, an issuer signals that it has nothing to hide. See also IOSCO Report (p. 6): Issuers value credit ratings because they lower the costs issuers pay for capital. Credit ratings reassure investors both about the risks they face when making an investment and by serving to reassure them about the competence and responsibility of management. Where investors are reassured, they tend to demand lower returns on their investments. 40 Although CRAs offer ancillary services and perceive subscription fees, the bulk of their revenues stems from fees by issuers for ratings. See Claire A. Hill, Regulating the Rating Agencies, 82 Wash. U.L.Q. 43 (2004): Moodys estimates that fees paid by issuers for ratings comprise ninety percent of its revenues (Moodys Corp. Services, 2002 Annual Report 16 (2003)). The AMF Report notes that this percentage is in any case higher than 80% (p. 18). 41 See SEC Report, p. 23: In general, hearing participants did not believe that reliance by credit rating agencies on issuer fees leads to significant conflicts of interest, or otherwise calls into question the overall objectivity of credit ratings. While the issuer-fee model naturally creates the potential for conflict of interest and ratings inflation, most were of the view that this conflict is manageable and, for the most part, has been effectively addressed by credit rating agencies. The rating agencies take the position that their reputation for issuing objective and credible ratings is of paramount importance, and that they would loathe to jeopardize that reputation to mollify a particular issuer. Furthermore, the rating agencies have implemented a number of policies and procedures designed to assure the independence and objectivity of

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Amlie Champsaur Sections 2.1 to 2.16.42 However, the fact that CRAs sometimes provide certain ancillary services in addition to credit ratings is considered as the greatest potential source of conflict of interest in the CRA/issuer relationship insofar as, as it happened in the financial analyst and accounting sectors, issuers may use the incentive of providing the CRA with more ancillary business in order to obtain higher ratings. 43 CRAs indicate that they deal with this issue by either refusing to provide ancillary services or setting up firewalls between the two lines of business.44 The IOSCO Code does not prohibit CRAs from providing ancillary services, but indicates that the CRA should separate its credit rating business and CRA analysts from any other business of the CRA, including consulting businesses, that may present a conflict of interest (2.5) and that the CRA and its employees should not, either implicitly or explicitly, give issuers any assurance or guarantee of a particular rating prior to a rating assessment (1.14). Conflicts of interest may also arise in the CRAs relations with its subscribers. CRA have access to
the ratings process, such as requiring rating decisions to be made by a ratings committee, imposing investment restrictions, and adhering to fixed-fee schedules. () While most hearing participants agreed that, for the most part, the rating agencies had effectively managed this potential conflict, they stressed the importance of credit rating agencies implementing stringent firewalls, independent compensation, and other related procedures. 42 See IOSCO Code in Annex A hereto. 43 The AMF Report indicates that these services include (i) comprehensive analyses of ratings for investors and market professionals, who are often paying subscribers; (ii) access to databases and tools for research and credit risk modeling (although these services may be spun off in a subsidiary); (iii) general information services, such as general news, macroeconomic and industry analysis, impact of current events, market trends, and credit default surveys; and (iv) rating assessment services for strategic projects, which involve giving an opinion on potential ratings, given scenarios described by the issuer for strategic acquisitions, mergers and spin-offs. These opinions are not published and CRAs providing these services reserve the right to change the rating once the transaction has been completed. 44 AMF Report, p. 18. CRAs consider that rating assessment services are different from rating advisory services provided by banks in that CRAs do not advise issuers on what structures to implement in order to obtain or maintain a given rating. However, one CRA stated that in some cases, a request from an issuer could create an inappropriate level of conflict, in particular in the case of hostile takeovers. It has been pointed out that the provision of rating assessment services may be particularly critical in terms of potential conflicts in the business of rating securitization and other structured finance vehicles, since the vehicles rating is crucial to the way the operation is structured. However, neither CESR nor the SEC are of the opinion that, despite this increased conflict of interest risk, this type of rating merits a special regulatory treatment other than an organizational structure and rules and procedures designed to avoid such conflicts in general.

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Amlie Champsaur confidential information on issuers and may be tempted to sell it to their subscribers. In the E.U., this issue is dealt with under the Market Abuse Directive.45 In the U.S., SEC Regulation FD prohibits the disclosure of selective information by issuers but exempts NRSROs.46 As a result, the SECs Proposed Rule suggests that this issue be dealt with through internal procedures preventing conflicts of interest and the misuse of confidential information, including confidentiality agreements. The IOSCO Code states that: the CRAs should use confidential information only for purposes related to their rating activities or otherwise in accordance with their confidentiality agreements with the issuer (3.12). Once they have determined an issuers or a debt instruments credit rating, CRAs usually publish them on their website, after having informed the issuer in order for it to verify that the rating is based on accurate, up-to-date information and does not reflect non public information. Therefore, the ratings are made available at no cost to third parties, such as investors, financial intermediaries and regulators: there are many more
45

See CESR Report (n.122-145). CRAs are not specifically exempted entities under the European Parliament and Council Directive 2003/6/EC on insider dealing and market manipulation (http://europa.eu.int/eur-lex/pri/en/oj/dat/2003/l_096/l_09620030412en00160025.pdf) (the Market Abuse Directive). However CESR considers that they are in a position to fall under the Article 6 exception providing that an issuer may delay the normally immediate obligation to disclose inside information if it relates to a matter which is subject to ongoing negotiations, or if disclosure would cause prejudice to legitimate interests, provided the issuer can keep the information confidential and the delay does not mislead the public. 46 See Selective Disclosure and Insider Trading, Release No. 34-43154 (August 15, 2000), 65 FR 51716 and SEC Report (p. 22): Generally, Regulation FD prohibits an issuer of securities, or persons acting on behalf of the issuer, from communicating nonpublic information to certain enumerated persons in general, securities market professionals or others who may well use the information for trading unless the information is publicly disclosed. When Regulation FD was adopted, the Commission exempted rating agencies not just NRSROs from Regulation FD, on the condition that nonpublic information is communicated to a rating agency solely for the purpose of developing a credit rating and that the credit rating is publicly available. The Commission believed it was appropriate to provide this exclusion from the coverage of Regulation FD because rating agencies have a mission of public disclosure. Under this exemption, the ratings process results in a widely available publication of the rating when it is completed. As a result, the impact of non-public information on the creditworthiness of an issuer is publicly disseminated, without disclosing the information itself. In addition to the specific rating agency exemption in Regulation FD, rating agencies may be able to avail themselves of the exemption for persons who expressly agree to maintain the disclosed information in confidence.

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Amlie Champsaur direct users of credit ratings than CRA clients. Why would CRAs accept that, instead of disclosing the rating merely to the issuer, who then can make it available to investors, lender or regulator if it so wishes? One hypothesis is that credit ratings have no real value to third parties and that the CRAs do not lose value by not selling them this information, since they would not be ready to pay for it anyway. Another hypothesis is that credit ratings are public goods: they are valuable for third parties but CRAs are compensated for this loss of value by other means, such as overcharging issuers and being afforded a regulatory monopoly. Since information about CRAs is not readily available, and since no antitrust inquiries into the CRA market have to our knowledge been initiated either in the U.S. or the E.U., it is difficult to assess whether the major CRAs are taking advantage of a dominant position.47 CRAs changed their business model in the 1970s in order to have the issuers, rather than end-users, pay for the ratings. This seems to suggest that, since CRAs determined that issuers were ready to pay more for credit ratings and/or that more issuers than investors and other subscribers were ready to pay for credit ratings, credit ratings are more valuable to issuers than to any other parties or, in the alternative, that issuers may be coerced or at least strongly incentivized by end-users (regulators and investors) to purchase and publish credit ratings.

II.
47

The multiple values of credit ratings

See Claire A. Hill, Regulating the Rating Agencies, 82 Wash. U.L.Q. 43 (2004): Moody's and Standard & Poor's are quite profitable, as far as can be determined. Standard & Poor's is a division of McGraw-Hill, and profit figures are not released separately. But Moody's' profit margins have been as high as fifty percent leading one analyst to characterize Moody's as "the best franchise [he's] ever covered in [his] 20 years on Wall Street." The same analyst estimated that S & P "has margins of a lower, but still enviable, 30 percent." Fitch, like Standard & Poor's, is wholly owned by a private company; its profits are therefore similarly impossible to determine. There is some reason, though, to suppose that it is less profitable than the other two. Its market share is far smaller, its market position is apparently far weaker, and its fees have been estimated by some market participants to be appreciably less than those of Moody's and Standard & Poor's.

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Amlie Champsaur

Since their reliability has been questioned after a series of scandals CRAs failed to foresee48, one may ask why and how are issuers incentivized into purchasing credit ratings (even double ratings for the same issue, generally)?49 Empirical evidence points to the fact that investors, lenders, fiduciaries and other market participants tend to rely on credit ratings in order to make investment and lending decisions.50 To a certain extent, regulators encourage the use of credit ratings by designating certain CRAs as credible providers of credit ratings. Private parties also use them increasingly in the context of private credit agreements. Whether this reliance by investors, lenders, and regulators is reasonable and justified remains to be established, but the value of credit ratings to a substantial number of participants seems uncontested.51

Claire A Hill, Rating Agencies Behaving Badly: the Case of Enron, 35 Conn. L. Rev. 1145 (2003) Claire A. Hill, Regulating the Rating Agencies, 82 Wash. U.L.Q. 43 (2004): Issuers typically attempt to obtain both Moody's and Standard & Poor's ratings, and very occasionally use Fitch as a third rating. Fitch may, for instance, be used for a third rating if Moody's and Standard and Poor's disagree. () There is, in effect, a two-rating norm, where the two ratings are those of Moody's and Standard & Poor's. Once established, this norm easily persists. () Just as the buyer of debt securities has no incentive to violate the two-rating norm, neither does the buyer of the rating - the issuer of the debt securities and its CEO. Rating agencies' fees, while perhaps supra-competitive, pale in comparison to the size of most rated debt offerings. A CEO may be second-guessed if he does not get two ratings and the offering is disappointing; a downside for not abiding by the norm is far more likely than any upside from flouting it. Probably most importantly, the second rating may very well pay for itself in the form of more advantageous financing rates. Should the two-rating norm show some sign of eroding, Moody's and Standard & Poor's can reinforce it by threatening to issue ratings the issuer has not solicited, using only the information publicly available. The implicit threat is always that without an issuer's active participation in (and payment for) the rating, the issuer will not be given an opportunity to rebut any negative inferences that might be made from the public information. How might such a norm have come about? Perhaps one firm thought to use two ratings to signal that it had nothing to hide. Others followed suit, and before long a norm had developed. This conclusion follows most readily if markets think a second rater is well situated to detect something the first rater may have missed. Nevertheless, even if the markets believed that the second rating provided almost no information other than the company's willingness to expose itself to additional scrutiny, the norm might very well have arisen. 50 See for instance Fernando Gonzalez et alii, Lincidence des notations sur les dynamiques de marche: une revue de la litterature, Banque de France, Revue de la Stabilite Financiere No.4 (2004). 51 Thomas L. Friedman, A manifesto for the Fast World, N.Y. Times Mag., March 28, 1999: The United States can destroy you by dropping bombs, and [rating agencies] can destroy you by downgrading your bonds. Steven L. Schwarcz, Private Ordering of Public Markets: the Rating Agency Paradox, U. Ill. L. Rev. 1 (2002): To a large extent, the almost universal demand by investors for ratings makes rating agencies gatekeepers of the types of securities that investors will purchase.
49

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Amlie Champsaur

A.

The informational value of credit ratings

It is generally considered that credit ratings play an essential role in securities markets, insofar as they help reduce information asymmetries between investors and issuers. Credit ratings promote market efficiency both informational efficiency and allocation efficiency by allowing issuers to signal their credit worthiness to lenders, thus helping lenders allocate capital to creditworthy borrowers.52 Also, due to their synthetic, simplified character, credit ratings allow investors to easily compare entities belonging operating in different countries and economic sectors.53 Nevertheless, whether credit ratings have an actual informational value is debated.54 First, studies indicate that CRA are usually slower than the market in revising credit ratings, which would seem to indicate that credit ratings do not reflect information

52

See SEC Report (p. 27): Credit ratings can play a significant role in the investment decisions of investors, and the value investors place on such ratings is evident from, among other things, the impact ratings have on an issuers ability to access capital. 53 Steven L. Schwarcz, Private Ordering of Public Markets: the Rating Agency Paradox, U. Ill. L. Rev. 1 (2002): The existence and almost universal acceptance of ratings make it much easier for investors in the capital markets to assess the creditworthiness of a given issuance of securities. In this sense, ratings can be thought of as a public good. Certain rating agencies even "view their ratings as worldwide standards, and not as relative risk standards within countries." Thus, a BBB rating on securities is intended to convey the same level of risk regardless of the jurisdiction in which the securities are issued. This sometimes creates a problem for companies that would otherwise have high ratings, but which are located in countries that have political or financial instabilities because the rating on the company's securities usually is limited by the rating of the country itself. On the other hand, the growing need for ratings has the salutary effect of motivating foreign companies and foreign governments to increase their transparency by providing the type of information needed to support a higher rating. 54 See in particular Frank Partnoy, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, 7 Wash. U. L. Q. 619, 658 (1999) and The Paradox of Credit Ratings, in Ratings, Rating Agencies and the Global Financial System (Richard M. Levich et al. eds., 2002), arguing that credit spreads have a superior informational value than credit ratings. See for the view that credit spreads may not be more accurate since they may also reflect liquidity risk, Catherine Lubochinsky, Quel credit accorder aux spreads de credit?, Banque de France, Revue de la Stabilite Financiere (November 2002)

19

Amlie Champsaur that the market does not already have.55 Second, credit ratings have an informational value to the market to the extent that the information that they provide is unique, i.e. not available from any other source. However, investors and other market participants use credit ratings as part of their investment decisions, but they are do not simply rely on credit ratings: they also take use their own research, and credit ratings are useful insofar as they confirm or challenge investors own findings.56 One reason why credit ratings do not have a more significant impact on investment decisions and thus, debt instruments prices, could be that credit risk is only one of the components of the risk that investors request to be compensated for (in addition to liquidity risk and systematic risk). Another explanation can be found in the methods used to determine credit ratings. Credit ratings often reflect CRAs assessment of entities long-term, relative creditworthiness, through the cycle, therefore their elasticity to short term variations due to overall market variations is limited.57 In addition, for practical reasons, credit ratings can obviously not be revised simultaneously with market changes, so it is likely that credit ratings will

The AMF report indicates (p. 53) that according to numerous studies, the results of which are sometimes equivocal, credit ratings are a factor in explaining changes in the price of debt instruments, both on the debt market, securitization and credit derivatives markets. However, changes in credit ratings have a limited impact on the price on the underlying security: downgrades have a greater impact than upgrades. This can be explained in two ways: first, investors risk aversion makes them react more strongly to bad news than good news. Second, upgrades seem to be better anticipated than downgrades since companies tend to disclose good news faster than bad news. In addition, ratings impact on price varies according to the economic sector. Finally, a ratings impact is stronger when the initial level of the rating is high 56 See SEC Report, p. 28 on the use of credit ratings by buy-side firms: Most of the large buy-side firms active in the fixed-income markets are substantial users of information from credit rating agencies, even though they typically conduct their own credit analysis for risk management purposes, or to identify pricing discrepancies for their trading operations. Buy-side firms use credit ratings as one of several important inputs to their own internal credit assessments and investment analyses. 57 See AMF Report, p. 53. For a discussion of the informational value of credit ratings and their impact on market prices, see A. Francois-Heude et E. Paget-Blanc, Les annonces de rating: impact sur le rendement des actions cotees sur Euronext-Paris, Banque et Marches, No 70 (2004); D. Kliger and O. Sarig, The Informational Value of Bond Ratings, Journal of Finance, Vol. 55 (2000); M. Micu et alii, The Price Impact of Rating Announcements: Evidence from the Credit Default Swap Market, BIS Quartely Review (2004)

55

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Amlie Champsaur adjust to new information slower than the market. Their predictive value is thus limited.
58

This slow CRA reactivity could be offset, to a certain extent, by the fact that CRA use confidential information obtained from issuers, in particular during meetings with management, such as issuers strategy, activity and budget forecasts, and publish credit ratings and/or rating revisions based on such confidential information, even though the information itself is not published. However, CRAs indicate that this

confidential information is not of the type that would, if it were disclosed, have a material impact on the debt instruments price, such material information being usually disclosed by the issuer to the CRA at the same time or very shortly before it is disclosed to the market.59 It seems, therefore, that their informational value does not suffice to justify the demand for credit ratings.

B.

The transactional value of credit ratings

Studies indicate that a significant and increasing part of CRAs turnover stems from the rating of securitization and other structured finance vehicles.60 CRAs have an essential function in the structuring of such operations, insofar as what banks seek to

58

The AMF Report (p. 52) notes the dilemma of CRAs: On the one hand, the agencies objective is to ensure a degree of permanence in their ratings, in keeping with the through the cycle, (long-term approach). This approach is aimed at ensuring predictability for market participants by providing them with a fundamental assessment of the risk of default by an issuer. This constancy presents an indisputable advantage when it comes to price formation, because it acts as a stabilizer. On the other hand, the agencies were urged to be more responsive, meaning that they should incorporate more short-term considerations into their ratings, which could potentially make their ratings more unstable. 59 See AMF Report (p. 46) and CESR Report (n.129) 60 See AMF Report (p. 22)

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Amlie Champsaur obtain is bankruptcy-remoteness, i.e. the highest possible credit rating for a given vehicle, in order to facilitate asset refinancing. In this context, it seems that credit ratings value is not due only to their informational content, because a high rating is the very purpose of the transaction. It may stem instead from the certification process, the CRA guaranteeing to a certain extent the legal validity of the asset sale, and thus in the CRAs independence and expertise in assessing credit risk. In this situation, CRAs fulfill a function similar to that of external auditors. CRAs role is therefore more crucial and difficult to replace in this context (as opposed to buy-side firms developing their own assessment of credit risk and using credit ratings as a tool among others): they are instrumental in creating legal rights and making the transaction possible instead of simply reducing transaction and capital costs.61 Credit ratings are also used in the context of loan agreement provisions. Pursuant to rating triggers clauses, lenders become entitled, upon a CRA downgrading the issuers debt, to exercise certain rights (e.g., interest rate rise, immediate acceleration, etc).62 These rating triggers have a function identical to that of financial covenants, in that they constitute contingent events of default. Rating triggers guarantee a certain level of protection to lenders and thus help simplify negotiations and reduce transaction costs, as well as lenders monitoring costs. As with structured finance transactions, the value of
A CRA may be in a position of creating legal rights when it rates an SPV AAA, because it thereby certifies that the transfer of rights from the originator to the SPV constitutes a true sale and therefore that investors in the SPV will still be repaid in the event of originator bankruptcy. This activity creates an important risk of conflict of interest: if a CRA helps structure the transaction and also rates the special vehicles credit risk, it risks not being independent in the rating process and not being perceived as reliable in asserting that the SPV is AAA. For a discussion of the conservative bias of CRAs when rating securitization vehicles, see Steven L. Schwarcz, Private Ordering of Public Markets: the Rating Agency Paradox, U. Ill. L. Rev. 1 (2002). 62 See Moodys Special Comment, Rating Triggers in Europe: Limited Awareness but Widely Used Among Corporate Issuers (2002); Standard & Poors, Survey on Rating Triggers, Contingent Calls on Liquidity (2002), and Fitch Survey (2002). These studies show that around 50% of U.S. and European investmentgrade debt issuers are exposed to rating triggers, but that these clauses are not widely used in the leveraged and high-yield markets.
61

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Amlie Champsaur credit ratings as triggers is not only informational: it also lies also in their simplified, synthetic form and their independence. From the parties perspective, a rating downgrade is a public, easily identifiable, external event, with a given date and therefore easily enforceable as an event of default against the borrower, since it can hardly be questioned as such (as opposed to what constitute cross default or insolvency events, for instance). Therefore credit ratings used as triggers also help strengthen legal rights, in this case, quasi-mechanical enforcement rights for the lender against the borrower. In a private, transactional context, credit ratings are valuable to the parties not only because they reduce informational asymmetries and thus reduce costs, but also because they facilitate the creation and enforcement of legal rights.63 Even though credit ratings are only an assessment, an opinion, they are used and relied upon in this context as if they were completely objective indicators of credit risk. In this case, the fact that they may not be reliable does not directly impact the CRA credibility and reputation as it would on the debt market: the immediate consequences are borne mainly by third parties.

C. The regulatory value of credit ratings

Securities and banking regulators in the U.S. and the E.U. rely increasingly on credit ratings. In the U.S., the NRSRO designation has been in place since 1975. The SEC initially created it in order to facilitate the application of the net capital rule to broker-dealers. Rule 15c3-1 provides that favorable net capital

63

See European Central Bank, Market Dynamics Associated with Credit Ratings. A Literature Review, Occasional Paper Series No. 16 (2004)

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Amlie Champsaur requirements apply to investment grade securities held by broker-dealers. In order to determine whether a security was investment grade, the SEC elected to rely on CRAs that were widely and reasonably relied on by the marketplace instead of making its own credit risk assessments.64 The SEC, other state and federal regulators and the legislator have since then incorporated reliance on NRSROs for an increasing number of regulatory purposes, the most important of which are (i) Rule 2a-7 of the Investment Act, that limits money market fund investments to high quality short term securities, NRSRO ratings being used to establish minimum quality standards, and (ii) Form S3 of the Securities Act of 1933, which is a short form registration statement eligible only for nonconvertible debt, preferred securities, and asset-backed securities rated investment-grade by at least one NRSRO.65 Regulatory reliance on CRAs is not as developed in the E.U. as it is in the U.S.66 As opposed to the first Basel agreement, the Basel II Agreement seeks to implement capital requirements based on the bank counterparts actual credit quality, instead of a priori credit assessments based solely on the debt belonging to a certain category. The standardized approach under the Basel II Agreement thus provides that
SEC Report, p. 6: The net capital requires broker-dealers, when computing net capital, to deduct from their net worth certain percentages of the market value of their proprietary securities positions. A primary purpose of these haircuts is to provide a margin of safety against losses that might be incurred by brokerdealers as a result of market fluctuations in the prices of, or lack of liquidity in, their proprietary positions. The Commission determined that it was appropriate to apply a lower haircut to securities held by a brokerdealer that were rated investment grade by a credit rating agency of national repute, because those securities typically were more liquid and less volatile in price than securities that were not so highly rated. The requirement that the credit rating agency be nationally recognized was designed to ensure that its ratings were credible and reasonably relied upon by the marketplace 65 For other instances of SEC reliance on credit ratings for regulatory purposes, see SEC report p.7-8. For a discussion of the increasing reliance by U.S. regulators on credit ratings, see Amy K. Rhodes, The Role of the SEC in the Regulation of the Rating Agencies: Well-Placed Reliance or Free-Market Interference?, 20 Seton Hall Legis. J. 293 (1996) 66 See Basel Committee on Banking Supervision, Credit Ratings and Complementary Sources of CREdit Quality Information, Working Papers No. 3 (2000). Most E.U. countries do not rely on CRAs for regulatory purposes, except for the purpose of evaluating market risk, as provided in the Basel I Agreement.
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Amlie Champsaur banks will have the option of determining credit quality on the basis of credit ratings provided by external rating entities, including CRAs.67 At this stage, the implementation of Basel II in the U.S. has not given rise to discussions on the need to reassess the NRSRO designation in this particular context. In the E.U., Basel II is being implemented in the form of the CRD, which was adopted by the E.U. Commission in July 2004. The CRD provides that, in order to calculate their counterpartys credit quality, banks may use external credit ratings, provided the external credit assessment institutions (ECAIs) issuing them was designated as eligible by national authorities.68 If an ECAI has been recognized as eligible by the competent authorities of a member State, the competent authorities of other member States may recognize the ECAI as eligible without carrying their own evaluation process.69 The ECAI process creates a less direct regulatory reliance on CRAs than the NRSRO system. First, CRAs are not the only entities that national authorities may choose to recognize as being eligible ECAIs: certain credit insurers, as well as publicly owned entities carrying out credit risk evaluation may also apply. In addition, credit quality is not based directly on the ECAIs credit ratings: national regulators in the E.U. member states are required to carry out a mapping process, i.e. to establish a valid correlation between ECAI-provided ratings and actual risk weightings of a particular
See Howell E. Jackson, The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy, in Regulating financial services and markets in the 21st century, Ed. Eils Ferran and Charles A.E. Goodhart. Oxford, Portland, Or., Hart Pub (2001). 68 Article 80 of the CRD provides that: To calculate risk-weighted exposure amounts, risk weights shall be applied to all exposures , unless deducted from own funds (). The application of risk weights shall be based on the exposure class to which the exposure is assigned and () its credit quality. Credit quality may be determined by reference to the credit assessments of external credit assessment institutions (ECAIs) in accordance with the provisions of Articles 81 to 83 or the credit assessments of Export Credit Agencies (). Article 81 provides that: 1. An external credit assessment may be used to determine the risk weight of an exposure in accordance with Article 80 only if the ECAI which provides it has been recognized as eligible for those purposes by the competent authorities , hereinafter an eligible ECAI) 69 See CRD Article 81.3. This provision creates a European passport for ECAIs in the E.U.
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Amlie Champsaur debt.70 External credit ratings are valuable to regulators insofar as they allow them to externalize a function that would be too difficult and costly for regulators to carry out themselves. Reliance on CRAs is an efficient tool for regulators insofar its substitute would be for regulators either to find alternative and admittedly more complex regulatory schemes or to rely on internal based ratings. However, incorporating credit ratings as part of the legislative and/or regulatory structure is valuable to regulators only to the extent that the delegation of competence to the CRAs is complete: the efficiency (in terms of cost/benefit analysis) of this reliance on CRAs as a regulatory tool is reduced if the regulator has to exercise a pervasive oversight of CRAs. To a certain extent, they are more valuable to the SEC regulators than E.U. banking regulators because the delegation of power to CRAs is almost complete in the case of NRSROs whereas the CRD places an important burden on E.U. member States regulators to continuously supervise ECAIs and monitor their performance.71 NRSRO and ECAI regulation could converge however

CRD Annex VI, Part 2.3 Mapping. In order to differentiate between the relative degrees of risk expressed by each credit assessment, competent authorities shall consider quantitative factors (such as the long term default rate associated with all items assigned the same credit assessment by the ECAI) and qualitative factors (such as the pool of issuers the ECAI covers, the range of credit assessments that the ECAI assigns, each credit assessments meaning and the ECAIs definition of what constitutes an event of default. The mapping process requirement results from the Basel II Agreement (n.92-95). 71 CRD Annex VI, Parts 2.1 Methodology: The E.U. member States competent authorities are required to verify that (i) an ECAIs methodology for assigning credit assessments is rigorous, systematic, continuous and subject to validation based on historical experience; (ii) such methodology is free from external political influences or constraints, and from economic pressures that may influence the credit assessment (independence shall be assessed based on ownership and organization structure, financial resources, staffing and expertise, and corporate governance of the ECAI; (iii) credit assessments are subject to ongoing review and are responsive to changes in the financial conditions (such review shall take place after all significant events and at least annually, backtesting must be established for at least one year prior to recognition, the regularity of the review process must be monitored by the national regulators, national regulators must be able to receive from the ECAI the extent of its contacts with the senior management of the entities which it rates, and ECAIs must promptly inform regulators of any material changes in the methodology they use for assigning credit assessments); and (iv) the principles of methodology employed by the ECAI for the formulation of its credit assessments are publicly available, in order to allow all potential users to decide whether they are derived in a reasonable way. CRD Annex VI, Parts 2.2 Individual credit assessments. The E.U. member States competent authorities are required to verify that ECAIs credit assessments (i) are recognized as credible by the users (such credibility being assessed on the basis of (a) ECAI market share, (b) revenues generated by the ECAI, and

70

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Amlie Champsaur if the SECs Proposed Rule is adopted, since the Proposed Rule, by defining specific criteria that CRAs must meet in order to maintain their NRSRO designation, would introduce a form of ongoing oversight of CRA conduct of business rules similar to that set forth in the CRD.72 In addition to being valuable to regulators, credit ratings used in a regulatory context are valuable to issuers insofar as they guarantee access to favorable, lighter regulatory treatment either directly (access to the integrated disclosure system, for instance), or indirectly, by rendering them more attractive to their counterparties (e.g. banks and money market funds). CRAs have even been considered as being

principally engaged in the business of selling regulatory licenses.73 Although this view has been challenged, 74 the regulatory value of credit ratings nonetheless provides at least a partial explanation for the persistently high demand for credit ratings despite proven shortcomings in their informational input and predictive capability.
more generally its financial resources, and (c) whether there is any pricing on the basis of the rating); and (ii) accessible in equivalent terms at least to all parties having a legitimate interest in these individual credit assessments, and in particular, available to non-domestic parties on equivalent terms as to domestic parties . 72 In particular, the second and third elements of the NRSRO definition set forth in the SECs Proposed Rule (the fact that the CRA (i) must be generally accepted in the financial markets as an issuer of credible and reliable ratings, including ratings for a particular industry or geographic segment, by the predominant users of securities ratings; and (ii) must use systematic procedures designed to ensure credible and reliable ratings, manage potential conflicts of interest, and prevent the misuse of non-public information and has sufficient financial resources to ensure compliance with those procedures) are largely similar to ECAI requirements. However, as opposed to the obligations imposed by the CRD on E.U. member states regulators, the SEC does not wish to bind itself to supervise NRSRO on an ongoing basis, but rather to continue using the no-action letter process: Like any staff no-action position, the staffs views on whether an entity meets the definition of NRSRO would be conditioned on the facts and representations made by the entity. Of course, if the facts and circumstances upon which the staff relied to provide its guidance change, the staff position may no longer be applicable. In this regard, given the changing market conditions in this context, we understand that the staff will include expiration dates in NRSRO no-action letters that it issues. In addition, the staffs views on issues may change from time-to-time, in light of reexamination, new considerations, or changing conditions that indicate that its earlier views are no longer in keeping with the objectives of the proposed NRSRO rule or with the regulatory use NRSRO ratings. (p. 58-59). Accordingly, the Proposed Rule does not mention additional regulatory and supervision costs to the regulator in Section VI. Consideration of the Costs and Benefits of the Proposed Rule. 73 See in particular Frank Partnoy, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, 7 Wash. U. L. Q. 619, 658 (1999) and The Paradox of Credit Ratings, in Ratings, Rating Agencies and the Global Financial System (Richard M. Levich et al. eds., 2002). 74 Claire A. Hill, Regulating the Rating Agencies, 82 Wash. U.L.Q. 43 (2004).

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Amlie Champsaur Although ratings are assigned pursuant to a contractual relation between the CRA and the issuer exclusively, other market participants and regulators also find value in those ratings. These parties could use alternative sources of information on issuers or alternative regulatory schemes. On the other hand, credit ratings have a unique value to issuers and thus are less substitutable for them, due to credit ratings transactional and regulatory value: even if investors tend to consider that credit ratings do not have a strong informational value, issuers will nevertheless be willing to purchase them because they are essential to in giving them access to favorable transactional and regulatory treatment. As a result, credit ratings might tend to become disconnected for their primary purpose, which is to provide information on credit ratings, which might in turn threaten credit ratings reliability.75

III.

Reliance without reliability? Justifying regulatory intervention

The IOSCO Code indicates that: The [IOSCO Report] highlighted the growing and sometimes controversial importance placed on CRA assessments and opinions, and found that, in some cases, CRAs activity is not always well understood by investors and issuers alike. Given to this lack of understanding, and because CRAs

For an illustration, see Basel Committee on Banking Supervision, Credit Ratings and Complementary Sources of Credit Quality Information, Working Papers No. 3 (2000): Ratings-based financial regulation can potentially alter the incentives that credit rating agencies face. In the absence of regulatory use of ratings, the only value of ratings to an issuer lies in the credibility of the signal it sends to potential investors about credit quality. However, the situation changes when credit ratings determine the conditions, if any, on which an investor may buy a particular bond. A regulated investor might prefer that a credit rating on a bond simply be high enough so that it can be included in its portfolio, rather than accurately reflect the issuers default risk. Under such a scenario, it is at least conceivable that an unprincipled rating agency would implicitly collude with a risky issuer and investors wishing to skirt portfolio restrictions by providing an inflated rating.

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Amlie Champsaur typically are subject to little formal regulation or oversight in most jurisdictions, concerns have been raised regarding the manner in which CRAs protect the integrity of the rating process, ensure that investors and issuers are treated fairly, and safeguard confidential material information provided them by issuers. In Section II, it was established that investors, banks and regulators rely on credit ratings for an increasing variety of purposes. In light of the IOSCO comments, it is necessary to inquire whether this reliance is reasonable. In other terms, is this a case of reliance without reliability, which would be a form of market failure justifying regulatory intervention into the CRA recognition process and/or in the way CRA conduct their activity?

A.

Are credit ratings reliable?

Reliability means two distinct things when it comes to credit ratings: (i) the result of the rating process, i.e. the accuracy of the credit risk assessment and (ii) the credibility of the process itself, i.e, an assessment that is independent from any of the parties who have an interest in it. Accuracy is essential for all parties who use credit ratings, and particularly for issuers: if investors do not trust that ratings reflect the issuers actual creditworthiness, and believe that, for instance, a particular issuer or debt issue is overrated, issuers will have more difficulty obtaining low cost ratings. Credit ratings are valuable to lenders and investors, who will have an incentive and be in a position to request them from issuers, only if it effectively saves them the costs of researching information and monitoring borrowers. In addition, in regard of the fact that in certain instances, credit ratings are considered by users to be as reliable as financial accounting figures, and integrated as such in transactional and regulatory schemes that

29

Amlie Champsaur entail certain legal consequences (and not only cost savings and investment decisions), it seems necessary to continuously ensure not only that they are an accurate reflection of the issuers credit risk, but also that they are and are viewed by all parties as stemming from an independent source. In the case of rating triggers, for instance, it is essential for the enforceability of the lenders right that the rating assessment be legally considered as an event truly independent from both parties, failing which the clause could be considered null and void. Studies conducted by CRAs themselves as well as other empirical studies tend to show that credit ratings are usually reliable, in the sense that they generally provide a correct assessment of an issuers or debt instruments credit risk.76 In addition, in cases such as the Enron collapse, CRA argued they should not be held responsible for failing to detect fraud, since verifying the accuracy of financial and other information through a due diligence process was not part of their work.77 If credit ratings value rested only on their unique informational input and the reliability of this information, the failure of CRAs to provide accurate, up-to-date ratings would be sanctioned by market forces, acting on reputational incentives.78 Credit

For a description of CRAs and other empirical studies showing a consistent correlation between credit ratings, and both historical default rates and credit spreads, see Amy K. Rhodes, The Role of the SEC in the Regulation of the Rating Agencies: Well-Placed Reliance or Free-Market Interference?, 20 Seton Hall Legis. J. 293 (1996). 77 Rating the raters, Enron and the Credit Rating Agencies, Hearings before the Senate Committee on Governmental Affairs, 107th Congress (March 2002). Some agree that CRAs are under no legal or regulatory obligation to detect fraud but that they behaved badly in some cases, most notably during the Asian Flu in 1997 and in their coverage of Enron. See Claire A. Hill, Rating Agencies Behaving Badly, 35 Conn. L. Rev. 1145 (2003) and Report of the Staff of the Senate Committee on Governmental Affairs: Financial Oversight of Enron: the SEC and Private Sector Watchdogs, S. Prt. 107-75 (October 7, 2002). Criticisms include (i) taking Enron at its word, and failing to probe more deeply; (ii) taking too narrow a focus in determining what Enrons problems were, focusing on short-term problems such as cash flow rather than deeply rooted problems such as suspect accounting; and (iii) not viewing themselves as accountable for their actions, notwithstanding the enormous market power their wield. 78 See Amy K. Rhodes, The Role of the SEC in the Regulation of the Rating Agencies: Well-Placed Reliance or Free-Market Interference?, 20 Seton Hall Legis. J. 293 (1996): Despite the fee arrangements

76

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Amlie Champsaur ratings would become too expensive for issuers to be worth buying and seeking credit ratings would actually increase lenders transaction costs. But, as it was shown above, incentive distortions may impede the markets ability to ensure credit rating accuracy. Due to extrinsic and not intrinsic characteristics (the fact that they are in synthetic, immediately understandable form and because there are no substitutes fulfilling that specific function, not because they provide an accurate assessment of credit risk), the demand for credit ratings seems to certain extent to be inelastic to price and possibly also to performance, as measured in terms of reliability.79 The widespread use of credit ratings and the fact that they are de facto not treated as mere opinions but incorporated in loan agreements and regulatory schemes thus tends to create a mechanical demand that may prevent the possibility of CRA regulation market-based mechanisms. In particular, if afforded the advantage of inelastic demand conditions, CRAs are less likely to have reputational concerns if they perform badly. Therefore, even if taken individually, CRAs may be considered as competent and generally provide accurate and independent assessments, the market structure itself may not create adequate self-regulation conditions. Furthermore, the NRSRO designation system does not seem sufficient in itself to guarantee reliability. The SEC not only relies on CRAs for regulatory purposes, but also relies on the markets appreciation of credible CRAs in order to designate
and reliance on information directly provided by the issuer, rating agencies are not apt to overrate or underrate issuers due to strong market forces. See Howell E. Jackson, The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy, in Regulating financial services and markets in the 21st century, Ed. Eils Ferran and Charles A.E. Goodhart. Oxford, Portland, Or., Hart Pub (2001): To preserve the value of their ratings (), credit agencies need to maintain a good reputation for accurate ratings, and the desire of the agencies to maintain their reputations enhances the credibility of ratings. () This alignment of interests is what makes the market work in this area. 79 The inelasticity of demand to price might explain the high margins that have been observed in the CRA industry (see n.)

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Amlie Champsaur them as NRSROs.80 Far from trying to ensure CRA reliability, the NRSRO approach relies on market efficiency to discipline CRA behavior and incite performance and thus to select CRAs. However, due to the markets above-mentioned potential incapability to properly adjust to CRA performance, this approach seems to be circular and the SEC seems to have acknowledged its limitations as a regulatory tool by proposing more precise criteria for granting NRSRO designation.81 If the Proposed Rule is adopted, a CRA will not be recognized as an NRSRO on the sole basis of the nationally recognized criteria, but on a general market acceptance basis, which could potentially allow the designation of smaller, specialized, and/or foreign CRAs. Also, by requiring that, in addition to being accepted by the market, the CRA adopts reliable methodologies and prevents conflicts of interest and the misuse of confidential information, and has sufficient resources to comply with those procedures, the SEC is giving less weight to the credibility criteria, which, although objective, is difficult and takes time to fulfill, and more weight to factors that (i) might allow more CRAs to enter the market, thus making reliance on market mechanisms to regulate CRA performance more justified and (ii) are likely to create incentives for CRAs to comply with the corporate governance rules of the type set forth in the IOSCO Code. Therefore, the Proposed Rule is more likely than the current NRSRO system to create the market conditions that might ensure an increased accuracy and independence of credit ratings.
80

See SEC Report. The NRSRO designation procedure is admittedly obscure, but the SEC acknowledges that it is based on a large extent on whether the CRA is nationally recognized by users of credit ratings. 81 See n.7. An NRSRO is an entity (i) that issues publicly available credit ratings that are current assessments of the creditworthiness of obligors with respect to specific securities or money market instruments; (ii) is generally accepted in the financial markets as an issuer of credible and reliable ratings, including ratings for a particular industry or geographic segment, by the predominant users of securities ratings; and (iii) uses systematic procedures designed to ensure credible and reliable ratings, manage potential conflicts of interest, and prevent the misuse of non-public information and has sufficient financial resources to ensure compliance with those procedures.

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Amlie Champsaur

B.

Regardless of reliability, reliance itself creates systemic risk

It could be argued that there is not real need to regulate CRAs in order to ensure the accuracy and independence of credit ratings, since regulation is costly and serves only the purpose of protecting unsophisticated investors who do not have the competence and resources necessary to conduct their own, in-depth credit analysis. Disclosure of CRAs conflicts of interest and methodologies should be sufficient for those investors to assess whether credit ratings are reliable and to discourage them from using such credit ratings if they consider that not to be the case. In other terms, one may question the need to regulate CRAs if it serves only the purpose of protecting investors, who should know better than taking credit ratings for granted. However, credit ratings are not exclusively used as credit risk assessments, which investors would be at liberty to disregard. Due to their incorporation into a variety of contractual and regulatory

structures, investors and lenders no longer have the option to rely on them or not: they have to assume and hope that credit ratings are reliable. More critically, a lack of credit rating reliability may have effects on third party and on the market in general. The inaccuracy of credit ratings could distort the markets allocational incentives, cost structures and competition. For instance, when E.U. banks will be able to use credit ratings in order to calculate capital requirements, banks will have an incentive to select highly rated borrowers if only because it mechanically lowers their capital requirements. If credit ratings do not adequately reflect credit risk, the banks capital structure might give the illusory impression that it constitutes a sufficient cushion against risk, which could threaten the safety and soundness of the banking system. In

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Amlie Champsaur addition, the Basel II Agreement, the purpose of which was to ensure a less random reflection of credit risk in capital requirements than its predecessor, would have failed its mission. In any case, grafting a market mechanism into a regulatory standard that the mechanism was not initially designed to serve creates specific concerns, even if credit risk is accurately assessed by CRAs.82 Another example of distortion is that lenders who request that borrowers include rating triggers in loan agreements obtain automatic enforcement rights in case of borrower default, on the sole basis of the rating. Therefore, they have less of an incentive to monitor their borrowers actual credit risk and other risks. But CRAs do not have the same incentive as banks to monitor borrowers, since they do not incur a financial risk in the case of borrower default. Therefore, irrespective of the accuracy of credit ratings, the banks unique function in assessing, closely and on a permanent basis, a borrowers overall financial structure and risks, may in some cases no longer be fulfilled, creating risks for the safety and soundness of the banking system. Furthermore, the inclusion of rating triggers in loan agreements creates the risk that an investor will be pushed into default due to the mechanical triggering of downgrades, with the default on a particular loan leading to cross defaults, requirements to pledge collateral, adjustments of interest rates and coupons and accelerations, thereby escalating a liquidity crisis which could then spread to affiliates and creditors (directly, if
See Howell E. Jackson, The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy, in Regulating financial services and markets in the 21st century, Ed. Eils Ferran and Charles A.E. Goodhart. Oxford, Portland, Or., Hart Pub (2001): One version of this concern derives from observations that credit rating agencies tend to raise the credit rating of borrowers in economic boom times and lower the credit ratings in times of economic difficulty. While this practice may accurately reflect default risk to investors and thus be a sensible practice in the context of the traditional role of credit rating agencies it has a potentially perverse effect if incorporated into government-imposed capital requirements. It allows banks to lower their capital requirements in economic expansion, but requires an increase in capital requirements in economic downturns. This is precisely the opposite of what financial economists suggest to be the optimal approach for capital standards.
82

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Amlie Champsaur debtor default is itself a third party event of default, or indirectly). In addition, the passage from an investment-grade to a speculative rating might also entail the loss of a number of favorable regulatory treatments and thus, increase solvency issues. In this situation known as a credit cliff, even an accurate rating can potentially cause chain events and disruptions to the financial system, which the parties to the loan agreement had not foreseen.83 Disclosure of rating triggers, which is still largely incomplete,84 might help foster a better understanding of these clauses and of their potential effects, although it will likely not prevent rating events from disturbing markets once the triggers are activated.85 In view of the discrepancy between reliance and reliability (what credit ratings are and what they should be or what the marketplace expect them to be) and the dangers of reliance per se, two concurring policy options would seem to make sense: increasing reliability of and decreasing reliance on credit ratings.

83

For a description of the dangers associated with rating triggers, see for instance European Central Bank, Market Dynamics Associated with Credit Ratings. A Literature Review, Occasional Paper Series No. 16 (2004): Credit cliff is the market jargon for a situation in which dire consequences, i.e. compounding credit deterioration, possibly leading to default, may be expected should certain risk scenarios materialize. In this regard, S&P has stated that in these cases, if there is a rating change, it will necessarily be a very substantial change (due to) the entitys greater sensitivity to credit quality or a particular occurrence. This can put material pressure on the companys liquidity or its business. For example, when downgraded, the position of a company that is performing poorly will worsen as its cost of capital rises. Rating triggers and other covenants, particularly when combined, can contribute to the development of such credit cliffs and may speed up the pace at which the cost of capital increases due to credit deterioration. This is especially the case in situations where multiple triggers are set off simultaneously, or when the triggering of one clause leads to an accumulation of negative consequences. 84 See CESR Technical Advice (n.178-180). CESR considers that Commissions Regulation No 809/2004 implementing Directive 2003/71 on the prospectus to be published when securities are offered to the public or admitted to trading, could be understood as requiring issuers to disclose covenants with lenders which could have material effect of restricting the use of credit facilities. In addition, the SEC intends to explore whether issuers should be required to provide more extensive public disclosure regarding such triggers (SEC Report, p. 29). 85 European Central Bank, Market Dynamics Associated with Credit Ratings. A Literature Review, Occasional Paper Series No. 16 (2004

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Amlie Champsaur IV. The CRA regulation options

CESRs Technical Advice to the E.U. Commission advocates a nonlegislative, self-regulatory solution, based on (i) the implementation by CRAs of the IOSCO Code, (ii) enforcement of the Market Abuse Directive to the extent that it applies to CRAs, and (iii) recognition and ongoing supervision of CRAs pursuant to and within the limited scope of the CRD. In its November 2004 Consultation Paper, CESR had outlined 6 options for CRA regulation, ranging from pervasive and specific CRA regulation, including registration of CRAs in the E.U. and integration of the IOSCO Code in E.U. legislation (Option 1) to self-regulation and basically wait and see (Option 6), the one that was finally chosen. This Section describes why Option 6 seems to be an appropriate way to deal with the main issues arising in connection with CRA activities in the E.U. context, including in comparison to the SECs approach in the Proposed Rule; in particular, self-regulation is not equivalent to no regulation but rather the most efficient way to implement the policy objectives outlined above.

A.

Regulating credit ratings

Taking into account the increasing reliance of market participants and regulators on credit ratings, a first option would have been to regulate credit ratings themselves in order to guarantee that they were reliable. This could be described as an

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Amlie Champsaur accounting standards type of regulation. It would entail precise substantive rules governing credit rating methodologies in order to ensure that credit ratings are accurate. This option in based on some of the main characteristics of the CRA market and activities: (i) de facto reliability on credit ratings and thus the need for them to be reliable, (ii) credit ratings being to a certain extent public goods, and (iii) the oligopolistic nature of the CRA market and the fact that, regardless of the existence of anticompetitive practices, the deteriorating quality or decreasingly informational value of credit ratings may not suffice for market mechanisms to regulate the CRA market and eliminate non performing CRAs. This option is appealing theoretically because the regulatory frame it imposes on CRAs would make up for the regulators delegation of powers to CRAs: it would limit the danger inherent to the privatization of regulatory functions by closely supervising the entities to which the regulators powers are delegated and the way in which they fulfill their mission.86 Nevertheless, this option raises serious legal and practical issues. The first is that, although investors and regulators perceive credit ratings as accurate indicators of credit risk, legislators, courts and regulators both in the U.S. and the E.U. consistently define them as opinions and consider that there should be no substantive regulation of credit rating methodologies.87 U.S. courts even have considered that investors reliance on credit ratings as though they were guarantees of a certain level of credit risk was unreasonable.88

86

The extreme tendency of this option would be to nationalize CRAs, given that they form a natural oligopoly, produce public goods, and fulfill regulatory functions. 87 See supra n.38 88 Quinn v. McGraw-Hill, 168 F.3d 331 (7th Cir. 1999) at 336

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Amlie Champsaur Treating credit ratings as opinions makes sense from a policy point of view. First, CESR, SEC and IOSCO as well as most commentators agree that requiring credit ratings to meet certain substantive standards would discourage innovation and would excessively burdensome and costly. Second, it is consistent with the way credit ratings are produced and the fact that they comprise both objective information and subjective, sometimes even predictive assessments.89 As opposed to financial statements, credit ratings do not seek to present existing information according to certain conventions, in order to make them comparable, they seek to produce new information, by analyzing a set of different factors (CRAs will not all use the same relevant factors) using CRA-specific and constantly evolving methodologies. Of course financial statements are also to a certain extent opinions, but they are based on conventional accounting rules, whereas there is no convention between CRAs as to what credit risk actually is. CRAs produce not only credit ratings, but their own definition of what credit risk means in the context of a particular entity. Absent a consensus on the definition and measurement of credit risk, regulating credit ratings substantively seems difficult at this stage. However, the fact that credit ratings should be considered as opinions for the time being does not necessarily entail that CRAs should not be regulated at all. It is possible to take an analogy with journalism ethics: not regulating contents does not mean not regulating at all. Enacting and establishing a professional code of conduct is a way, if not of guaranteeing accuracy of the result, at least of ensuring integrity of the process. Opinions cannot be required to be accurate, but it does not mean they can be allowed to

89

See supra Section I.B

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Amlie Champsaur be random or unreasonable and that CRAs should not be responsible for the process through which they are assigned and published.

B.

Regulating CRA activities: establishing conduct of business rules

Instead of regulating credit ratings, it may be possible to regulate CRA activities, as a means to ensure credit rating reliability. This could be described as the financial analyst type of regulation. It acknowledges that credit ratings are opinions and does not require that credit ratings be substantively accurate or comply with certain specific conventions. It merely imposes conduct of business rules in order to ensure the integrity of the credit rating process, with respect to the establishment of contacts and commercial relations with the issuer, the collection of information from the issuer, the fair and skilled treatment and analysis of such information, including the provision of adequate and sufficient information on how the rating was determined, and the disclosure of credit ratings to the issuer and the market. In addition, reliability implies independence of CRAs from outside influences that may corrupt this process: CRAs should therefore avoid impropriety as well as the appearance of impropriety, which implies dealing with conflicts of interests which may arise in the CRAs relation to both issuers and subscribers.90 The IOSCO Code advocates two types of methods: (i) the adoption by CRAs of internal rules, procedures and mechanisms91, and (ii) disclosure, either to the

90 91

See supra Section I.C See IOSCO Code (Annex A hereto): Procedures, rules and mechanisms include the implementation or rigorous and systematic methodologies (1.1-1.4), the employment of skilled, competent and impartial staff (1.11-1.16, 2.10), record-keeping (1.5), resource adequacy (1.7), permanent monitoring of issuers and rating review (1.9), fair dealings with issuers and investors (1.12, 2.1-2.5), analyst independence (2.11-

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Amlie Champsaur general public or to the issuer, in the context of particular ratings.92 Market participants, including CRAs, have unanimously approved the IOSCO high-level principles and the IOSCO Code, as establishing a set of complete and coherent rules of conduct for CRAs and being an appropriate response to the above-mentioned issues. CESR in its Technical Advice recommends that CRAs implement its provisions insofar as the Code adjusts the balance between different interests in the rating market.93 The implementation by CRAs of the rules set forth in the IOSCO Code seems likely to bridge the gap between reliance on and reliability of credit ratings. The internal rules, procedures and mechanisms described above, in particular with respect to CRA staff, Chinese walls, and treatment of confidential information, would ensure greater reliability (i.e. integrity and independence) of credit ratings. Disclosure, in

particular with respect to credit rating process and methodologies, and conflicts of interest, would ensure greater transparency about the limitations inherent to the credit rating process and therefore likely discourage excessive and misplaced reliance on credit ratings. In particular, although IOSCO and CESR do not mention it, it would seem useful for CRA to remind issuers and the market, upon each credit rating publication, that ratings are only opinions, at a particular time, on the creditworthiness of the issuer or debt instrument, based on a certain assumptions about the issuer and the market, and that they
2.14), appointment of a compliance officer (1.15), separation between ratings and ancillary activities (2.5, 2.9, 2.10), transparency and timeliness of ratings publication (3.1-3.9), and protection of confidential information transmitted by the issuer (3.10-3.18). 92 See IOSCO Code (Annex A hereto): Disclosure obligations include decision by a CRA to discontinue rating an issuer (1.10), actual and potential conflicts of interest (2.6-2.7), general nature of CRAs compensation arrangements with rated entities (2.8), existing and any changes/updates in rating methodologies (3.9), procedures, and assumptions, key elements underlying particular rating decisions, including time horizon, rating distribution and publication policies (3.4-3.6), and historical default rates (3.7). 93 See CESR Technical Advice (n.255): CESR if of the opinion that, overall, the substance of the IOSCO Code is the right answer to the issues raised by the Commissions mandate () as it will improve the quality and integrity of the rating process and enhance the transparency of CRAs operations.

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Amlie Champsaur should not be considered as or relied upon as a guarantee of a certain level of credit risk. As it was shown above, increased reliability and diminished reliance will also likely reduce the systemic risk attached to the various uses of credit ratings. Although there appears to be a consensus on the fact that the implementation of the IOSCO Code would be beneficial to all parties involved, at the lowest cost for both CRAs and regulators, there seem to be few guarantees that it will effectively be enforced.

C.

Enforcing conduct of business rules

The surest way to ensure CRA compliance with the IOSCO Code or with IOSCO Code-type principles would be to require CRA registration and ongoing oversight as a condition of conducting their activities in the E.U. (with a E.U. passport/mutual recognition system) and in the U.S. as is the case for banks, thus acknowledging that CRA activities involve public interest and systemic risk issues.94 Mandatory registration would give regulators the opportunity to examine CRAs capital structure, resources, level of staff competence, record-keeping, etc and the threat of temporarily or permanently losing the CRA license upon periodic examination of IOSCO Code compliance would likely be the strongest possible incentive for CRAs to comply with those rules and would allow regulatory elimination of non performing CRAs. However there are strong objections to this solution, which may reflect more than just industry capture. First, in the E.U. there is already a recognition/ongoing oversight procedure under the CRD, and creating another structure for the purpose of enforcing the IOSCO
94

See the E.U. Parliament Report (and supra, n.16)

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Amlie Champsaur Code would be to a large extent duplicative and burdensome for CRAs and regulators. On the other hand, CESR points out that relying solely on the CRD procedure integrating IOSCO rules as an element of CRD recognition/oversight might not be a sufficient incentive for CRAs to comply with IOSCO rules, since (i) not all CRAs might seek CRD recognition, and (ii) criteria examined for the purpose of CRD recognition95 are used only to ensure that CRAs can be relied on to determine risk-weighting exposures, and thus that they are reasonably reliable, whereas IOSCO and securities regulators are concerned with a wider range of issues, such as credit ratings impact on the market, and thus with disclosure, presentation and information flow matters. CESR argues however that those securities concerns can be for the most part dealt with under the Market Abuse Directive.96 A second objection is that a registration system would create additional barriers to entry in an already oligopolistic market, and further decrease the possibility of CRA market self-regulation. Interestingly enough however, the

smallest CRAs, who should be advocating lower barriers to entry, are the only market participants in favor of a registration procedure, insofar as it would place more importance on tangible, immediately attainable factors (staff competence, resources, etc) rather than the credibility criteria. CESR notes that a lighter form of registration (i.e. a voluntary, periodically renewable recognition system including reporting mechanisms) might be more efficient in terms of balancing compliance, competition and regulatory costs concerns and that, in any case, competition concerns should be dealt with not by

95

High-level principles are included in the CRD (see supra, n.71) and CEBS (the Committee of European Banking Supervisors) is currently working on a more specific set of criteria. 96 CESR Technical Advice, n. 235-245 (arguing against the inclusion of the IOSCO Code within the CRDs recognition procedure)

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Amlie Champsaur securities or banking regulators, but by competition authorities.97 The third and main objection to a registration or even voluntary recognition procedure, both in the U.S. and in the E.U., is that there have not been market failures great enough to justify such a pervasive level of CRA regulation.98 CESR argues that CRAs have a sufficient reputational incentive to enact and disclose their own codes of conduct, which would integrate the IOSCO Code while going into further detail as regards the application of each rule. The fact that certain CRAs have promptly drafted and published codes of conduct seems to support this argument.99 In any case, publishing a code of conduct is certainly viewed by the market as promoting CRAs credibility, which is one of their key assets. The first reason is that, since credit ratings are opinions, their strength resides, as for journalistic publications, in their credibility after-the-fact, when they prove on the long term to have been consistently reasonable, impartial, thorough and trustworthy. The second reason is that credibility is a factor that is taken into account in order for CRAs to be recognized for regulatory purposes, both in the U.S. and the E.U.100 Because a solid reputation can only build on
97

CESR Technical Advice, n. 252: CESR is of the opinion that the impact of regulatory requirements on competition is not clear and therefore cannot conclude that any regulatory requirements would either increase or decrease the entry barriers to the rating industry. Thus CESR does not recommend the use of regulatory requirements as a measure to reduce or remove entry barriers to the market for credit ratings. 98 See CESR Technical Advice, n. 260. The SEC merely states in the Proposed Rule (p.4) that this proposal is intended only to address the meaning of the term NRSRO as it is used by the Commission; it does not attempt to address may of the broader issues raised in response to the 2003 Concept Release. However, there may also be legal issues preventing pervasive regulation of CRAs I the U.S.. Commissioner Paul S. Atkins noted in a March 3, 2005 speech (Statement before the Open Meeting regarding NRSRO Proposing Release) that the limited approach taken in the current proposal reflects the SECs lack if statutory authority over NRSROs. 99 In September 2004, Standards & Poors published a code of conduct based on the IOSCO High Level Principles (www2.standardandpoors.com/spf/pdf/fixedincome/Code of PP 9-22-04.pdf) 100 The Proposed Rule proposes to require that an NRSROs is generally accepted in the financial markets as an issuer of credible and reliable ratings, including ratings for a particular industry or geographic segment, by the predominant users of securities ratings. Similarly, the CRD provides that the proven credibility of individual credit ratings is a criteria that national regulators must take into account in order to maintain recognition for regulatory purposes (see supra, n.71). The SEC currently uses the nationally recognized as the main criteria to grant CRAs NRSRO status. It seems that using credibility of ratings, as

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Amlie Champsaur the long term, CRAs have a strong incentive not to risk losing it, which not publishing a code of conduct would do in the present context. To a certain extent, the publication of the IOSCO Code and the fact that there are public and concurrent reflections and initiatives on the part of regulators creates a threat of regulatory intervention and reputational risk of non compliance, which in themselves might be sufficient to incentivize CRAs into applying the IOSCO rules. However, if publication of their code of conduct and greater disclosure by CRAs give their activity the appearance of integrity and independence, it does not guarantee that CRAs will effectively implement these rules, since there are no sanctions, liability or other forms of enforcement mechanisms in the case of non-compliance. There is no obvious third-party, international organization or professional association to which complaints about CRA violations could be brought and that could conduct investigations into such alleged violations. Since CRAs are generally privately-owned companies, it may not be possible to use corporate governance and securities laws to ensure an appropriate level of disclosure about the application of these rules. CESR suggests that the CRAs auditors could be in a position to assess compliance; however, assessing effective compliance would require a type of expertise if it is not to be a merely formal assessment that is not part of auditors missions. Therefore, the issue of CRA compliance remains open, both in the U.S. and in the E.U., in the form of a common wait and see approach.

established by their consistent use by predominant market users, as a criteria, is a good compromise. Instead of the national recognition of agencies, it permits regulators to designate a greater number of competent CRAs that have not yet achieved a sufficient reputation, while ensuring that credibility remains a factor, credibility being an essential way to assess ratings reliability, since ratings are only opinions.

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Amlie Champsaur Conclusion The table below summarizes the U.S. and E.U. current approaches to CRA regulation.
U.S. Main regulator Regulatory tools SEC No registration of CRAs, but recognition by SEC as NRSRO for regulatory purposes IOSCO Code SEC does not recommend adoption by CRAs of IOSCO Code, but the NRSRO recognition criteria relating to conduct of business rules seem likely to be achieved by implementing the Code. Recognition criteria - Published ratings - Market acceptance of CRAs - Conduct of business rules Recognition goals Efficiency of securities markets E.U. Bank supervisors No registration of CRAs, but recognition by bank regulators for regulatory purposes CESR recommends adoption by the CRAs of the IOSCO Code. There is no enforcement mechanism (CESR relies on market enforcement) - Integrity of methodologies - Credibility of ratings - Conduct of business rules - Efficiency of securities market (IOSCO Code) - Adequacy of capital requirements Ongoing supervision Limited (SEC reserves the right to reexamine conditions on which granted NRSRO status) Recognition procedure SEC discretion, although criteria are more precise under the Proposed Rule Civil liability Securities laws No (First Amendment protection) Exemption under Regulation FD Bank regulators are bound by the CRD rules and further details Never established but possible No exemption under the Market Abuse Directive Competition The SEC believes that more precise NRSRO designation criteria will foster competition and that competition is a means of regulating CRA performance CESR believes that competition issues should not be taken into account in establishing CRA rules and should be left to antitrust authorities. Permanent (as required by the CRD)

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Amlie Champsaur The above table seems to indicate that, as Commissioner Roel C. Campos wished, the treatment of CRAs in the U.S. and the E.U. is converging towards marketbased regulation, despite concerns due to the incorporation of credit ratings in securities laws and capital requirements regulatory schemes. The substantive conduct of business rules (based on transparency and independence) recommended by CESRs Technical Advice and by the SECs Proposed Rule, are largely identical and are based on the IOSCO Code of Conduct. However, the means of ensuring CRA compliance with those rules are still unclear. Both in the U.S. and in the E.U., it seems that enforcement actions with respect to CRAs will be taken only upon the occurrence of disasters and not as preventive steps. In the E.U., given the existence of other regimes applicable to CRAs (the CRD and the Market Abuse Directive), self-regulation through implementation of the IOSCO Code might actually be the most efficient way to deal with CRA issues, and not merely a regulation only as a last resort argument, provided the CRA market is efficient enough to pressure CRAs into implementing these rules. It is not certain, however, that the CRA market and business model allow the market to be truly efficient, i.e. to monitor CRA performance and actually eliminate non-performing or noncomplying CRAs. In the U.S., the lack of regulatory steps taken to ensure CRA compliance may be explained by the SECs limited authority to impose rules on CRAs. Nevertheless, the SECs assumption is that clearer rules with respect to the designation of NRSROs will foster competition and that a competitive market is likely to monitor performance. In addition, both in the E.U. and in the U.S., regulators count on the implicit threat of losing recognition status to force CRAs into compliance with conduct of business rules. In any case, the effects of the Proposed Rule, the implementation of the

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Amlie Champsaur CRD, and the adoption by CRAs of the IOSCO Code will have to be monitored over the next years in order to determine if and how they contribute to increased CRA performance and compliance, securities markets efficiency, and systemic risk.

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