European Commission Proposes Legislation to Improve Ratings Quality
Richard Powell | Bloomberg Law
Proposal for a Regulation amending Regulation (EC) No 1060/2009 on credit rating agencies – COM(2011) 747/2 of 15 November 2011; Proposal for a Directive amending Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to undertakings of collective investment in transferable securities (UCITS) and Directive 2011/61/EU on Alternative Investment Funds Managers in respect of the excessive reliance on credit ratings – COM(2011) 746/2 of 15 November 2011
Five months since his speech to the European Securities and Markets Authority (ESMA) setting out, amongst other matters, the European Commission’s plans for improving the quality of credit ratings,1 Michel Barnier, EU Commissioner for internal market and services, has published proposed legislation to bring these to fruition.2 This coincides with publication by the UK Financial Services Authority (FSA) of a study in its Occasional Paper Series (FSA Paper), which presents an economic analysis of credit ratings agencies (CRAs) and their accuracy.3 This offers useful background and context to the Commission’s plans.
The recent financial crisis and the current EU sovereign debt crisis have exposed major weaknesses in the regulation of CRAs. It appears that CRAs in the run up to 2008 overrated structured finance products which, when downgraded, created significant losses for investors.
Taking its lead from the Leaders’ Statement at the G-20 summit in Washington D.C. in November 2008, the EU adopted Regulation 1060/2009 (CRA Regulation), which introduced regulation of CRAs on an EU-wide basis. The CRA Regulation has since been amended by Regulation 513/2011 to reflect the enhanced role of ESMA as day-to-day supervisor. There are now, therefore, requirements on CRAs as regards registration and conduct of business with ESMA charged with their supervision.
The Commission’s latest initiative seeks to address a number of issues with the quality of ratings. These are outlined below.
— Investor Over-reliance on Ratings
Since the 1970s, issuers have increasingly been required to have their debt issues rated. Rules made by the U.S. Securities & Exchange Commission (SEC) in the 1970s, first permitted broker-dealers to have higher debt to capital ratios if the debt enjoyed a high ratings grade from a recognised ratings agency. In Europe, Basel II and III capital requirements have placed ratings at the heart of prudential regulation. In fact, one of the key issues with structured finance products is “of the general increase in demand for highly rated products rather than demand for products whose underlying quality would warrant a high rating.”4In this context, the Commission considers that investors rely too heavily on ratings, and moreover, have insufficient information available to reach their own view.
The Commission proposes that in future all authorised firms will have to reach their own credit risk assessment without relying only on ratings. In fact, a start has already been made. There are proposals to amend the Capital Requirements Directive (CRD IV)5 that would, for example, require banks to base their investment decisions not just on ratings, but on an internal credit opinion. The instant proposal will see amendments to Directive 2009/65/EC and Directive 2011/61/EU to reduce the fund sector’s reliance on ratings and to empower the Commission to make technical rules. Moreover, the three European Supervisory Authorities, of which ESMA is one, will have to avoid using external ratings in their guidelines. A further change will see ratings “Outlooks” (e.g., “stable,” “negative,” or “positive”) made subject to regulation.
As a corollary, investors will benefit from greater transparency. CRAs will have to provide more information about their processes and how they reach their views (e.g., by disclosing methodologies and assumptions). There will also be free access to a new European Rating Index, enabling comparison of all issuer paid ratings on an entity or financial instrument.
— Conflicts of Interest
There is concern that CRAs are insufficiently independent due to the preponderance of the “issuer pays model” to meet the cost of preparing ratings. This is a reversal of the position since the 1970s when the investor pays model dominated. According to the FSA, this is due to the ever greater complexity of financial products and increased demand from issuers to have their debt rated. Another factor was, apparently, the spread of photocopiers and therefore the ability to freely disseminate ratings information! The issuer pays model is said to encourage ratings shopping and ratings inflation as CRAs have sought to increase market share.
While a market analysis suggests that CRAs would be concerned about their reputation and therefore the quality of their ratings, according to the FSA Paper, this constraint is diminished by a low level of competition. There are currently just three major CRAs: Standard & Poor and Moody’s with 80 percent of the market between them and Fitch, with a further 14 percent. There are, though, numerous small regional or specialist CRAs.
The FSA Paper states nonetheless that the ratings inflation seen up to the financial crisis would still have happened even with a different business model. Regulatory action is justified because “consistently inaccurate ratings could pose a threat to financial stability by underestimating the riskiness of investments of regulated entities.”6
The issuer pays model remains under the Commission’s proposals, but the draft legislation contains a number of measures to increase the diversity and independence of CRAs. Besides limiting cross-holdings, of particular note, are the rule that two separate ratings will be needed for structured finance products (where the issuer pays model is used), and the “rotation rule.” The later would prevent a CRA, which uses the issuer pays model, from providing corporate ratings for more than three consecutive years coupled with a four year “cooling-off” period.
The Commission has though backed away from creating a public European CRA. This was considered as too costly in the current economic climate and there existed concerns over its perceived independence especially given political pressures.7
— Insufficient Transparency Over Sovereign Debt Ratings
There are concerns about the level of transparency surrounding the downgrading of sovereign debt ratings which it is claimed can impact negatively on financial stability. For this reason, the Commission wishes to impose additional information requirements to those already found in the CRA Regulation for ratings generally. Barnier has, however, stepped back from an earlier proposal to allow governments to check the data relied upon before an agency is permitted to downgrade. CRAs will, nonetheless, have to publish their ratings every six months rather than yearly as at present, and publication must take place when EU trading venues are closed with issuers receiving 24 hours notice.
— Civil Liability Regimes
Legal proceedings have been brought in the U.S. by investors following the financial crisis; there may not, however, be corresponding remedies everywhere in the EU. Moreover, at present, ESMA is limited to imposing administrative fines of up to €1.5 million (approximately $2 million) for breaches of the CRA Regulation. In this respect, the Commission expresses concern that CRAs (and possibly issuers) will engage in “jurisdiction shopping.”
The Commission therefore proposes amending the CRA Regulation to allow investors who suffer loss in any Member State to take legal proceedings against a CRA that intentionally or with “gross negligence” fails to fulfil its duties under the legislation. Controversially, perhaps, the burden of proof will be partially reversed as investors are unlikely to have detailed knowledge of the specific ratings process. Instead, a CRA would have to show that it took the necessary care. The actual “standard” to be applied though is not entirely clear from the wording of the proposed Regulation.
According to the Commission, these measures are broadly in line with steps taken internationally, and, in particular, with the Financial Stability Board’s principles8 to reduce over-reliance on ratings approved in the Leaders’ Statement at the G-20 summit in Seoul in November 2010. The Basel Committee on Banking Supervision and the SEC (e.g., through section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act) have also taken similar action.
The European Parliament and Member States will now consider the legislative proposals under the co-decision process. This involves the Parliament and Member States (through the European Council) reviewing the measures and reaching agreement after negotiation.
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