Regulation 2

8/3/2019 Regulation 2

http://slidepdf.com/reader/full/regulation-2 1/48

Amélie 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

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Contents

I. The credit rating business……………………………………………...…8

A. The credit rating market………………………………………………...8

B. The credit rating process………………………………………………11

C. The credit rating business model……………………………………...14

II. The multiple values of credit ratings……………………………………18

A. The informational value of credit ratings……………………...………19

B. The transactional value of credit ratings………………………………22

C. The regulatory value of credit ratings…………………………………24

III. Reliance without reliability? Justifying regulatory intervention……..29

A. Are credit ratings reliable?…………………………………………….29

B. Regardless of reliability, reliance itself creates systemic risk……...…33

IV. The CRA regulation options……………………………………………36

A. Regulating credit ratings………………………………………………37

B. Regulating CRA activities: establishing conduct of business rules…...39

C. Enforcing conduct of business rules…………………………………..41

Conclusion………………………………………………………………………..46

Annex A: IOSCO Code of Conduct

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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

1Rating 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;

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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 CRAs5

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/33-

8236.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)

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Amélie 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 CRA’s 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

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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. Parliament’s 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+A5-2004-

0040+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 ratings14

CESR’s Technical Advice to the European Commission on Possible Measures Concerning Credit Rating

Agencies: Consultation Paper, CESR 04-612b (November 2004)15 CESR’s 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 Chairman’s 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 ratingagencies 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.

Parliament’s initial strong stance in favor of a registration of CRAs in the E.U. (see E.U. Parliament

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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 alternativemethodology, which is subject to the explicit approval of the bank’s 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)

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Amélie 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 quasi-

unanimous 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/

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worldwide (Standard & Poors, Moody’s 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 (…) Moody’s and Standard &

Poors have a combined market share in excess of 80%, while Fitch’s market share is approximately 14%.

Aside from Fitch, there are a number of other rating agencies, both general purpose and specialized, but, asthe above numbers suggest, they are quite small relative to Moody’s 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 fromthose 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 CRA’s

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

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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

SEC’s Proposed Rule clarifying NRSRO designation process is to facilitate the entry of

new CRAs on the market, thereby enhancing market mechanisms which make self-

regulation 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 can’t get the designation unless they are nationally recognized, and they can’t 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 itsview, 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 Moody’s 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. Eilís 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 aparticular 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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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 CRA’s “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 issuer’s or a debt instrument’s

creditworthiness is not equivalent to an assessment of its value, thus a credit rating does not provide anopinion on the value of an issuer’s 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 Free-

Market 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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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 issuer’s or the debt

instrument’s 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 issuer’s 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

31AMF 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”.

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that this was not to suggest that CRAs should auditor otherwise ensure the accuracy of an

issuer’s 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

CRA’s methodology may helps the issuer and investors better understand the rating

process, but is not in sufficient to predict the CRA’s opinion on a particular issuer’s or

debt instrument’s 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

34 SEC Proposed Rule, p. 39.35 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=2436

See Basel Committee on Banking Supervision, Credit Ratings and Complementary Sources of CreditQuality 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 “ doesn’t 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. Moody’s Investor’s Servs., Inc., 988 F. Supp. 1341, 1348 (D.

Colo. 1997), aff’d, 175 F.3d 848 (10th

Cir. 1999). For a discussion of First Amendment issues, see also

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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 issuer’s 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 LimitedOversight 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 issuer’s own views about the issue for which it is

obtaining a rating. (…) An issuer typically gets ratings from both Moody’s 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): “Moody’s estimates that fees paid by issuers for ratings comprise ninety percent of its revenues”

(Moody’s Corp. Services, 2002 Annual Report 16 (2003)). The AMF Report notes that this percentage is inany 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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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 CRA’s 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 agreedthat, 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 vehicle’s

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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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 SEC’s 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 issuer’s or a debt instrument’s 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 ratingagencies – 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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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 1970’s 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. The multiple values of credit ratings

47

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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Amélie 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

48

Claire A Hill, Rating Agencies Behaving Badly: the Case of Enron, 35 Conn. L. Rev. 1145 (2003) 49 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 thetwo-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 almostno 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, L’incidence 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”.

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Amélie 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 issuer’s 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 therating 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)

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Amélie 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

55 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 rating’s impact is stronger when the initial level of the rating is high56 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, eventhough 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)

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Amélie 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 issuer’s 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 instrument’s 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

58The 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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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 rating’s 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 CRA’s 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 issuer’s 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 lender’s monitoring costs. As with structured finance transactions, the value of

61 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 specialvehicle’s 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 Moody’s 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 investment-

grade debt issuers are exposed to rating triggers, but that these clauses are not widely used in the leveraged

and high-yield markets.

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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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Amélie 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 counterpart’s 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

64SEC 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 broker-

dealers 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 broker-

dealer 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 itsratings 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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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 counterparty’s 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 ECAI’s 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

67 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. Eilís 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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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 ECAI’s

and monitor their performance.71 NRSRO and ECAI regulation could converge however

70 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 assessment’s meaning and the ECAI’s 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 ECAI’s 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 torecognition, 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 ECAI’s 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

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if the SEC’s 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 SEC’s 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 staff’s 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 itissues. In addition, the staff’s 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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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

75 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 regulationcan 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 issuer’s 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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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

issuer’s 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

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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 issuer’s 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 lender’s 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 issuer’s or debt instrument’s 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

76For 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 Enron’s 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

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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 market’s 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 market’s appreciation of “credible” CRAs in order to designate

and reliance on information directly provided by the issuer, rating agencies are not apt to overrate orunderrate 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. Eilís 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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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 market’s 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 acknowledgesthat 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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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 market’s 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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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 borrower’s

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

82

See Howell E. Jackson, The Role of Credit Rating Agencies in the Establishment of Capital Standardsfor Financial Institutions in a Global Economy, in Regulating financial services and markets in the 21

st

century, Ed. Eilís 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”.

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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 entity’s greater sensitivity to credit quality or a particular occurrence.” This

can put material pressure on the company’s 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 oneclause leads to an accumulation of negative consequences.”84 See CESR Technical Advice (n.178-180). CESR considers that Commission’s 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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IV. The CRA regulation options

CESR’s Technical Advice to the E.U. Commission advocates a non-

legislative, 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

SEC’s 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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“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 regulator’s 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 regulator’s 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.3888 Quinn v. McGraw-Hill, 168 F.3d 331 (7

thCir. 1999) at 336

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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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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 CRA’s 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

90See supra Section I.C

91 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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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 CRA’s

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 Commission’s mandate (…) as it will improve the

quality and integrity of the rating process and enhance the transparency of CRAs’ operations.”

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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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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 CRD’s

recognition procedure)

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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 SEC’s 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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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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Conclusion

The table below summarizes the U.S. and E.U. current approaches to CRA

regulation.

U.S. E.U.

Main regulator SEC Bank supervisors

Regulatory tools No registration of CRAs, but

recognition by SEC as NRSRO for

regulatory purposes

No registration of CRAs, but

recognition by bank regulators

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 beachieved by implementing the Code.

CESR recommends adoption by

the CRAs of the IOSCO Code.

There is no enforcement

mechanism (CESR relies onmarket enforcement)

Recognition criteria - Published ratings

- Market acceptance of CRAs

- Conduct of business rules

- Integrity of methodologies

- Credibility of ratings

- Conduct of business rules

Recognition goals Efficiency of securities markets - 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)

Permanent

(as required by the CRD)

Recognition procedure SEC discretion, although criteria are

more precise under the Proposed Rule

Bank regulators are bound by the

CRD rules and further details

Civil liability No (First Amendment protection) Never established but possible

Securities laws Exemption under Regulation FD 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.

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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 market-

based 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 CESR’s Technical

Advice and by the SEC’s 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 non-

complying CRAs. In the U.S., the lack of regulatory steps taken to ensure CRA

compliance may be explained by the SEC’s limited authority to impose rules on CRAs.

Nevertheless, the SEC’s 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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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.

***

Documents

Regulation 2