Legal column: Reforming CRAs

Many people were pointing the finger of blame at Credit Rating Agencies (CRAs) for the financial meltdown, blaming them for giving triple-A ratings to collateralised debt obligations (CDOs) and other toxic instruments that were stuffed with junk sub-prime elements. Jonathan Brogden, a partner at law firm, Davies Arnold Cooper, looks at the latest European Commission moves to reform the sector

On 2 June 2010, the European Commission (EC) published its proposals for improved supervision of Credit Rating Agencies in the European Union. The proposals seek to build on the regulations issued in 2009 (Reg 1060/2009), which established the basic framework for the regulation of CRAs in the EU.

The EC has taken a tough line in relation to the agencies on the basis that it considers they contributed to the financial crisis by underestimating the risk that the issuers of complex financial instruments might not repay their debts. The Commission has two stated aims concerning CRAs: ensuring efficient and centralised supervision at European level and increased transparency on the entities requesting the ratings, to improve competition in the market and enhance investor protection.

Under the new proposals, the European Securities and Markets Authority (ESMA) is proposed to be entrusted with exclusive supervisory powers over CRAs registered in the EU. With registration being a requirement for any CRA wishing to operate in the EU, this would include subsidiaries of all the main CRAs, namely Standard & Poor, Fitch and Moody’s.

The key features of the new proposals are for ESMA to be responsible for registration and supervision of CRAs in the EU. ESMA will monitor CRAs compliance with regulatory provisions and be empowered to sanction CRAs that breach regulations. So far as the supervisory power is concerned, Article 24(1) will give ESMA the power to take the following steps in response to certain defined infringements:
• withdraw registration
• temporarily prohibit CRAs from issuing ratings
• suspend the use of ratings issued by a CRA
• require a CRA to end the infringement
• require an issuer of a structured finance instrument to provide access, to CRAs requesting it, to information sufficient to enable that agency to issue a rating of its own
• issue public notices.

These sanctions can be issued against any CRA for failing to abide by some of the fundamental features of the regulatory framework – namely, failure to comply with stipulations concerning:
• conflicts of interests, organisational or operational requirements
• the requirement to keep records and audit trails
• disclosure provisions.

The EC proposals also envisage ESMA be empowered to issue fines where a CRA has intentionally or negligently committed a breach of the regulations. The fines are intended to be dissuasive and proportionate to the nature and seriousness of the breach and account for the economic capacity of the CRA concerned. Detailed criteria for the way in which fines are calculated do not yet form part of the regulations, but will clearly need to be developed.

A CRA faced with an alleged breach of regulation will have the right and ability to defend itself, in relation to which a right of access to information and documentation forming ESMA’s investigation will, broadly, exist. ESMA will also be required to provide details of any decision reached and to justify action taken.

It is envisaged that CRAs will benefit from regulation by ESMA thanks to the operation of a simpler and more co-ordinated supervisory environment. Users of ratings are envisaged to benefit in terms of higher quality ratings, greater transparency of rating activity, more effective protection through the co-ordinated supervisory regime, and consistent application of regulation. In particular, the requirement for issuers of structured finance instruments to provide access to information not only to the CRA it appoints, but also to all other interested CRAs will reinforce competition between CRAs, help avoid possible conflicts of interest and enhance transparency and the quality of ratings. The issuance of unsolicited ratings will also promote the use of more than one rating per financial instrument.

The new proposals, if adopted, will go some way to improving the regulatory regime under which CRAs operate in the EU. However, they do not address some of the more important issues that the European Commission recognise as still needing to be addressed – namely, whether the issuer pays model is sustainable; whether legislation relies too heavily on CRA ratings; whether the CRA market is too concentrated; and how to create more competition and diversity in the CRA market. Further proposals are expected to be issued shortly by the EC in this regard.

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