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Credit Rating Agencies

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Public (legislative and regulatory) uses of credit ratings ... (theoretically) pressure CRAs to be more sanguine in their ratings decisions ... – PowerPoint PPT presentation

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Title: Credit Rating Agencies


1
Credit Rating Agencies
  • Public and Private Uses of Credit Ratings
  • Christopher C. Nicholls

May 25, 2005
2
Four 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

3
Public (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.

4
Initiatives
  • 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)

7
Public 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

8
Provincial 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

9
Selected 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

10
Provincial 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

11
Selected 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)

13
Private 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)

14
Ratings 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)

15
Ratings 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

16
Liquidity 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)

17
Other 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

18
Potential Civil Liability for CRAs
  • Two principal potential sources of liability
  • Action brought by rated issuer
  • Action brought by third party users of ratings

19
Potential 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

20
Liability 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)

21
Liability 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)

22
Alternatives 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?

23
Alternatives 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

24
Conclusion
  • 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.

25
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