Title: Credit Rating Agencies
1Credit Rating Agencies
- Public and Private Uses of Credit Ratings
- Christopher C. Nicholls
May 25, 2005
2Four topics of investigation
- Public (legislative and regulatory) uses of
credit ratings - Private (uncontracted-for) uses of credit
ratings - Potential liability for credit rating agencies
arising from private use of ratings - Alternatives to the use of credit ratings
3Public (or Regulatory) Uses of Credit Ratings
- Such use documented in U.S.
- See, Financial Oversight of Enron The SEC and
Private-Sector Watchdogs, Report of the Staff of
the Senate Committee on Governmental Affairs
(October 8, 2002) at 101 ff. - SEC, Report on the Role and Function of Credit
Rating Agencies in the Operation of Securities
Markets (January 2003) at 28. - And Internationally
- See, e.g., Basel Committee on Banking
Supervision, Credit Ratings and Complementary
Sources of Credit Quality Information (July
2000) at 41 ff. - IOSCO Report on the Activities of Credit Rating
Agencies (September 2003) - Gonzalez et al., Market Dynamics Associated with
Credit Ratings (European Central Bank, June
2004) at 9. - 2004 AMF Report on Rating Agencies (January 2005)
at 37 ff.
4Initiatives
- Europe
- European Parliament Resolution (Feb. 2004)
- CESR Report to EC (March 2005)
- IOSCO
- Statement of Principles Regarding Credit Rating
Agencies - Code of Conduct Fundamentals for Credit Rating
Agencies (2004) (comply or explain approach)
5- Critical role of credit-rating agencies has
recently led to - Proposed Exchange Act Rule 3b-10 (re NRSROs)
- Proposes defining NRSRO in terms of 3
components - Free Public Availability/Current Assessments of
Creditworthiness - Market Acceptance
- Systematic Procedures (reliability, manage
conflicts, prevent misuse of confidential
information) and Adequate Resources
6- Suggestions in the U.S. that legislative
authority to oversee credit rating agencies might
be appropriate. - (See William H. Donaldson, Testimony before
the Senate Committee on Banking, Housing, and
Urban Affairs Concerning the State of the
Securities Industry (March 9, 2005)
7Public Use of Credit Ratings
- U.S.
- In U.S., credit ratings referenced in at least 8
federal statutes, 47 federal regulations, and
more than 100 state-level acts and regulations
(See Covitz Harrison, 2003 Report of the Staff
of the Senate Committee on Governmental Affairs) - Canada Federal
- At least 8 federal statutes (or regulations)
- Bank Act
- Canada Marine Act
- Canada Small Business Financing Act
- Civil Air Navigations Services Commercializations
Act - Co-operative Credit Association Act
- Income Tax Act
- Canadian Payments Act
8Provincial Legislation (other than Securities
laws)
- At least 37 provincial statutes (or regulations)
in addition to securities laws in which the
concept of credit ratings or approved/recognized
credit/bond rating agency is used
9Selected Examples of Regulatory Uses
- Investment Eligibility
- Proxy for Creditworthiness
- Net Capital and Prudential Regulation
- Specific Unique Examples
- E.g., Mine Development and Closure Regulations
(Ontario) - Cross Border Leases Relating to Toronto Transit
- Electrical Power Control Act
10Provincial Legislation (Securities Laws)
- At least 10 National Instruments or National
Policies use concept of approved credit ratings - Also included in a number of provincial
securities rules and regulatory instruments
11Selected Securities Law Uses
- Exemption from s. 76 (s.76(2)-other than in the
necessary course of business NP 51-201, s.
3.3(2)(g), 3.3(7)) - Exemption from s. 130 statutory civil liability
(Rule 41-501, s. 13.4(4) s. 130(1)(d)) - Eligibility for use of Short Form Prospectus for
certain debt and pref share issues (NI 44-101) - Eligibility to distribute securities under MJDS
(NI 71-101, s. 3.1(a)) - Requirements for money market funds (NI 81-102,
s. 1.1 (definition of money market funds and s.
15.3(5),(6)) - Proposed NI 45-106, registration and prospectus
exemption for commercial paper (NI 45-106, s.
2.36(1), (2))
12- credit ratings form part of the statutory
framework of provincial securities legislation - National Policy 51-201, s. 3.3(7)
13Private Uses of Credit Ratings
- Ratings Triggers
- Issues
- Propriety of using ratings triggers
- Effect of rating triggers on rating of issuer
(the circularity problem) - The forced seller problem
- Does existence of triggers make CRAs reluctant to
downgrade? - Disclosure issues (In US-Reg FD exemption)
14Ratings Triggers
- Issue Studied by CRAs, see, e.g.
- The Unintended Consequences of Ratings
Triggers(2001) (Pamela Stumpp (Moodys) ) - "Moody's Analysis of US Corporate Rating Triggers
Heightens Need for Increased Disclosure (2002) - Identifying Rating Triggers and Other Contingent
Calls on Liquidity(2002) (Solomon Samson (S P)
) - Few European Firms Hang at Credit Cliff (2002)
(SP)
15Ratings Triggers
- Among most well-known uses are
- Default/acceleration triggers in loan agreements
- Pricing grids
- Security/collateral enhancement triggers
- Benchmark for triggering restrictive negative
covenants - For calculation of borrowing base, and springing
liens - Qualification of permitted assignees
16Liquidity Implications
- Reporting issuers must disclose in liquidity
portion of M D A, ratings triggers that could
trigger an additional funding requirement or
early payment or that could impair your
companys ability to undertake transactions - Form 51-102 F1, Part 2, item 1.6, instruction (ii)
17Other Triggers
- Other triggerssuch as those affecting
pricingmight not be required to be disclosed in
M D A and yet may, in aggregate, be material to
an issuer - Not just downgrades that may adversely afffect
issuers
18Potential Civil Liability for CRAs
- Two principal potential sources of liability
- Action brought by rated issuer
- Action brought by third party users of ratings
19Potential Civil Liability
- Threat of action by rated issuers could
(theoretically) pressure CRAs to be more sanguine
in their ratings decisions - Threat of action by third-party users could
(theoretically) pressure CRAs to be more
conservative in their ratings decisions
20Liability to Third Parties
- Risk of Liability for CRAs to third party users
of ratings is low - Under securities laws, CRAs largely insulated
from statutory civil liability (e.g., Ontario
Securities Act s. 130)
21Liability of CRAs
- Common law
- Debatable whether prima facie duty of care under
first stage of Anns/Kamloops - Even if prima facie liability under first stage,
risk of indeterminate liability negatives duty
under second stage (Hercules Mangements) - Even if possible liability under Anns/Kamloops,
CRAs typically responsibility (Hedley Byrne)
22Alternatives to Credit Ratings
- From SEC Concept Release 33-8326
- Allow the use of internally-developed credit
ratings (by broker-dealers) (Conflicts?) - Industry SROs could set appropriate standards
- For investment eligibility purposes, subjective
tests could replace credit ratings (i.e., prudent
investment standards) - For short-form registration (Form S-3), other
tests such as investor sophistication,
denomination size, and (in case of ABS deals)
specified asset and structure experience
criteria - Coverage Ratios?
- Credit Spreads?
23Alternatives to Credit Ratings
- Private contracts If market regarded
alternatives as superior to credit ratings,
alternatives would be used - Regulatory uses Alternatives such as credit
spreads may not be an adequate substitute for
credit ratings because - Too volatiletoo many false negatives?
Stability is valued for credit ratings - Information asymmetry
24Conclusion
- Public and private uses of credit ratings are
useful, no superior alternative to credit ratings
for these purposes exists, and such use should
not be discouraged - Legislative and regulatory use of credit ratings
originally simply a reflection of market reality,
but now impacts the market - CRAs fundamentally different from registrants
- Regulation through control of designationwith
only sanction a removal of designationplaces
regulator in relationship with CRA similar to
CRAs relationship to rated issuer - However, no single regulatory or legislative
recognition of approved credit rating agencies
for Canadian purposes - Further, given the recognition of CRAs as NRSROs
in the U.S., and ECAIs for BIS purposes, unlikely
that Canadian regulators can (or should) act
unilaterally.
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