There appears to be a full-fledged assault on credit rating agencies taking place in the courts of the US, in the US Congress and in the European Union. This article explores recent developments.

There appears to be a full-fledged assault on credit rating agencies taking place in the courts of the US, in the US Congress and in the European Union. While most of the wrath is directed at credit rating agencies, admonitions have been given to investors whom regulators and others believe either willingly or unwillingly blindly accepted ratings at face value.

One such admonition was in fact embedded in the body of new rating agency regulation from the European Union.  The European Union has warned that “users of credit ratings should not rely blindly on credit ratings but should take utmost care to perform their own analysis and conduct appropriate due diligence at all times regarding their reliance on such credit ratings.” However, while the admonitions to investors have been accompanied by attempts to equip investors with more tools to enable them to make better investment decisions, credit rating agencies have been caricatured in the press and attacked from all sides and are perhaps experiencing one of the most difficult periods in the history of credit rating agencies.

Investors and some states in the US are seeking to use the courts to remedy what they perceive as credit rating agency abuses of the past, while regulators in the US and in the European Union are seeking to use a whole slew of new regulation to hold credit rating agencies accountable for their future rating actions and are seeking to equip investors with the tools to make more educated decisions about what instruments and/or entities to invest in. It is widely acknowledged that sophisticated investors had investment policies which restricted their corporate bond purchases to those that were in the upper tiers of investment grade ratings.

In fact, according to Alan Greenspan, the former chairman of the Federal Reserve, in a March 2010 paper entitled, ‘The Crisis,’ “an inordinately large part of investment management subcontracted to the “safe harbour” risk designations of the credit rating agencies. No further judgment was required of investment officers who believed they were effectively held harmless by the judgments of government sanctioned rating organisations.” This overreliance on credit rating agencies who bestowed ratings that in the words of Alan Greenspan were “grossly inflated” and “implied Aaa smooth-sailing for many a highly toxic derivative product” proved disastrous for many investors as the credit crisis took hold and they lost significant portions or all of their investments. It is therefore not surprising that investors, especially in the US, have sought remedy in the courts.

The Courts 

There are currently pending numerous lawsuits that have been brought by private entities and individual states of the US against credit rating agencies in the US.  Two of the most prominent cases against credit rating agencies playing out were filed in New York and in California.  Both cases are either partially or wholly the result of the collapse of a large Structured Investment Vehicle named Cheyne, which collapsed in 2007.

In California, the California Public Employees Retirement System, the largest pension fund in the US, filed a lawsuit against Moody’s, Standard & Poor’s and Fitch in July 2009. Calpers alleged that the rating agencies were indispensable in the structuring and issuance of the debt of three SIVs that Calpers had invested in and the rating agencies were subsequently paid huge fees by the issuers to rate their own work. The Calpers suit further alleged that by giving these SIVs their highest ratings, the rating agencies made negligent misrepresentations to Calpers on which Calpers relied and which caused Calpers to suffer substantial investment losses.

Calpers, in its lawsuit, confessed its blind reliance on the ratings because, as it said, “the SIVs were opaque” and “the rating agencies were the only ones (other than those running the SIV) with knowledge of what assets a SIV actually purchased” and “other than the rating agencies’ evaluation and subsequent credit rating of a SIV, an investor had no access to any information on which to base a judgment of a SIV’s creditworthiness.”  This lack of access to the information on which ratings are based, as alleged in the Calpers lawsuit, is something that new US legislation currently pending in Congress and new EU regulations relating to credit rating agencies - both discussed below - seek to remedy.

The Calpers suit also alleged that in addition to the high fees that rating agencies received for rating SIVs and their underlying assets, additional fees to the rating agencies were contingent on the SIV ultimately being offered to investors, which meant that there was an incentive to give high investment grade ratings in order for the rating agencies to receive their full fees. Calpers also alleged that no amount of actual diligence on the part of Calpers could have given Calpers actual knowledge of the conflicts of interest that existed and their effect on the quality of the ratings.

The New York case was a topic of discussion in the fall of 2009 because it struck a blow to one of the shields that credit rating agencies in the US have long used to protect themselves from liability.  In the New York case of Abu Dhabi Commercial Bank v Morgan Stanley & Co. Incorporated et al, the plaintiff, just like the plaintiffs in the Calpers lawsuit, alleged that the credit rating agencies played an integral role in the structuring and issuing of the SIV’s notes and structured them in such a way that the notes would qualify for the highest ratings.

In exchange for their services, the credit rating agencies received fees in excess of their normal fees and the credit rating agencies’ compensation, unbeknownst to the investors, was contingent upon the receipt of desired ratings and the transaction closing with those desired ratings. The plaintiffs also alleged that the ratings and the information that they conveyed were false and misleading; that the information was disseminated with the credit rating agencies’ knowledge and/or approval to potential investors, including the plaintiffs, and that as a result of this false and misleading information, the plaintiffs suffered significant losses.

Avoiding Liability

Rating agencies have been able to avoid liability for their ratings by relying on protections embedded in the US Constitution’s First Amendment freedom of speech principles because their ratings have been considered matters of public concern and are statements of opinion that are only actionable if there is a proven misstatement.  However, on 2 September 2009, a federal court in Manhattan chipped away at these protections as they relate to ratings for asset backed securities, securities which have been credited with exacerbating the financial crisis. 

In the Abu Dhabi Commercial Bank case, the court issued an opinion stating that the rating agencies could not rely on First Amendment protections because the plaintiffs had alleged that the defendants’ ratings were distributed to a select group of investors rather than the public at large and therefore not matters of public concern and because plaintiffs had alleged that that the credit rating agencies did not genuinely or reasonably believe that their ratings were accurate or had a basis in fact thereby making the ratings not mere opinions but actionable misrepresentations.

This ruling means that the rating agencies in the New York case cannot rely on any freedom of speech protections and must now spend a lot of time and significant sums of money mounting a defence against the allegations of misrepresentation. 

The New York opinion, although not binding in California or any other state of the US, could be considered by other courts as a persuasive argument against rating agencies asserting free speech protections. Furthermore, if the rating agencies are not successful in defending themselves against charges of misrepresentation in the New York case, together with California case, it could also encourage other investors who have lost money to file suits against the rating agencies who rated high grade securities that later turned out to be worthless.

In fact, the Attorney General for the State of Ohio, a state whose November 2009 suit against rating agencies charged “rating agencies with wreaking havoc on US financial markets by providing unjustified and inflated ratings of mortgage-backed securities in exchange for lucrative fees from securities issuers,” issued a rallying cry in March 2010 encouraging investors, whom he called “victims of rating agencies’ wrongdoing” in a March 2010 press release, to “review their legal rights and to determine whether they should file similar actions.”

Regulatory Actions in the United States of America and the European Union

The courts are not the only means by which individuals have sought to hold rating agencies accountable.  An April 2009 US Securities and Exchange Commission  roundtable to examine oversight of credit rating agencies noted that credit rating agency performance in the area of mortgage-backed securities backed by residential subprime loans and the collateralised debt obligations linked to such securities shook investor confidence to its core.

An European Commission December 2008 Impact Assessment noted that credit rating agencies issued excessively favourable opinions on structured instruments that were financially engineered to give investors high confidence in the instruments. In order to combat these market destabilising excesses of the past, the G-20 in its April 2009 communiqué agreed to extend regulatory oversight and registration to credit rating agencies to ensure that they meet an international code of good practice, particularly to prevent unacceptable conflicts of interest.

Later on in April 2009 in Europe, the European Parliament and the Council adopted proposals on the regulation of credit rating agencies.  And the US Treasury Department and the SEC are pursuing legislative and regulatory changes aimed at greater investor protection.   The Treasury Department’s July 2009 proposals sent to Congress and embodied in the Accountability and Transparency in Ratings Act of 2009 passed by the US House of Representatives in December 2009 and awaiting Senate approval, seek to bolster regulation of credit rating agencies.

Congressional Proposals

The proposals by the US Treasury Department, in the words of the Treasury Department, aim to increase transparency, tighten oversight, reduce reliance on credit rating agencies, reduce conflicts of interest at credit rating agencies and strengthen the SEC’s authority over and supervision of credit rating agencies.

The Accountability and Transparency in Rating Agencies Act of 2009 (the “Accountability and Transparency Act”) seeks mandatory registration with the SEC for all credit rating agencies, except those credit rating agencies that do not provide ratings to issuers for a fee and who publish ratings only in periodicals of general or regular circulation. Oversight of credit rating agencies will be tightened by annual reviews by the SEC which will look at the credit rating agencies’ procedures, methodologies and credit ratings. 

Credit rating agencies will be required to publish historical default rates for all of their rated financial products, have a board of directors, one-third of which must be made up of independent directors, and maintain and enforce policies to address conflicts of interest. Credit rating agencies will be required to review past ratings by an ex-employee where such employee takes a position at an obligor, issuer or underwriter who had an interest in ratings with which the employee had been involved while at the credit rating agency. Credit rating agencies will also be prohibited from providing any non-rating service to entities that they rate.

Credit rating agencies will also be required to submit annual reports to the SEC accompanied by certifications, akin to those required by corporations subject to the 2002 Sarbanes-Oxley Act, that, under penalty of law, the reports are accurate and complete. Preliminary ratings will also be required to be disclosed and made freely available along with any subsequent changes to those ratings.

One of the goals of this disclosure is to provide a gauge for the accuracy of ratings, which in turn will allow users of the ratings to compare performance across credit rating agencies. Credit rating agencies will also be required to disclose information about the assumptions underlying the procedures and methodologies used, and the data relied on, to determine a credit rating.

The Accountability and Transparency Act empowers the SEC to adopt rules that will require credit rating agencies to: adopt and use rating symbols that distinguish between structured and non-structured products, notify users of the version of a procedure or methodology used in relation to a particular credit rating; notify users when a change is made to a procedure or methodology, or when an error is identified in a procedure or methodology that may result in credit rating actions and the likelihood of the change resulting in current credit ratings being subject to rating actions. 

The use of third party due diligence services will also be required to be disclosed to the public. The Accountability and Transparency Act also will repeal Rule 436(g) of the Securities Act of 1933 which provides an exemption from liability under the Securities Act to certain credit rating agencies when their ratings are used in public offering documents.

The Accountability and Transparency Act also empowers investors by giving any purchaser of a rated security the right to sue to recover damages if the subject ratings process was grossly negligent and the grossly negligent process was a substantial factor in the economic loss suffered by the investor. Any such suit must be instituted within 2 years of discovery of the facts constituting the violation and within 3 years of the initial issuance of the rating at issue. 

New SEC Rules

In place since February 2009 are SEC final rules which require credit rating agencies to keep records of all rating actions (including preliminary ratings) and complaints about the performance of rating analysts and to make publicly available rating action information for a randomly selected ten percent of outstanding credit ratings (six months after such rating actions were issued) which were paid for by obligors, underwriters or sponsors of the securities being rated.

Rules adopted in November 2009 additionally require that beginning on 2 June 2010, credit rating agencies will also be required to disclose rating action histories for all of their ratings initially determined at any time after (and including) 26 June 2007. This second layer of disclosure will be required no later than 12 months after a ratings action is taken for issuer paid ratings and no later than 24 months after a ratings action is taken for others.

Annual reports furnished to the SEC will now be required to be accompanied by Sarbanes-Oxley type certifications which will require the person making the certification on behalf of the credit rating agency to state that to the best knowledge of such person, the financial reports fairly represent, in all material respects, the financial condition, results of operations, cash flows, revenues, analyst compensation, and credit actions of the credit rating agency for the period presented.

The February 2009 rules also extended the list of prohibited conflicts of interest to include: (a) situations where the credit rating agency or its employees make recommendations to the issuer, underwriter or sponsor of the security about the corporate or legal structure, assets, liabilities or activities of the obligor or issuer of the security, (b) situations where the fee paid for the rating is negotiated, discussed or arranged by a person within the credit rating agency who participates in developing the rating or approving procedures or methodologies used for determining ratings and (c) situations where an employee of a credit rating agency involved in the credit rating process receives gifts from the obligor being rated or from the issuer, underwriter or sponsor of the securities being rated, other than items provided in the normal context of business activities which do not have a value of over $25.

On 17 September 2009, the SEC adopted further rules which include requirements to provide greater information on rating histories and to allow competing credit rating agencies to offer unsolicited ratings for structured financial products by granting to them the necessary underlying data for structured products.
The SEC, on 17 September 2009, also decided to seek public comment on whether to remove the current exemption (afforded by Rule 436(g) of the Securities Act of 1933) from liability afforded to nationally recognised rating agencies when a rating is used in connection with an offering of securities registered with the SEC.

There have been many comments in support of extending liability, notably from the national association of US investment companies, the Investment Company Institute, who as early as 2002, at a November 2002 SEC hearing on ‘Issues Relating to Credit Rating Agencies,’ supported the idea that there should be no exemption for credit rating agencies from expert liability under the Securities Act of 1933.
Unsurprisingly, there have also been many comments, including from credit rating agencies, against extending such liability to crating agencies. 

Nevertheless, the SEC believes that rating agencies hold themselves out to investors as experts at analysing credit and risk.  Therefore in the SEC’s view, when credit ratings are used to sell securities, investors rely on credit rating agencies as experts and therefore it may be appropriate for liability to apply to all credit rating agencies as such experts.

Furthermore, although the credit rating agencies hold their ratings out as opinions, the SEC, in an October 2009 concept release on the rescission of Rule 436(g), notes that other opinions on which investors rely, provided by professionals such as lawyers and accountants, are subject to the liability provisions of the Securities Act of 1933 and it may not be consistent with investor protection to exempt the category of nationally recognised credit rating agencies from liability under the Securities Act of 1933.

Some comments to the SEC October 2009 Concept Release have raised constitutional and other objections to the SEC’s repeal of the aforementioned Section 436(g) indicating that the SEC has no power to do so. The House of Representatives has included the repeal of Section 436(g) in the Accountability and Transparency Act, therefore repeal of Section 436(g) may ultimately be out of the hands of the SEC and no matter what form the repeal takes, it may be subject to constitutional challenges in the courts of the US.

New European rules
A March 2009 review of the global banking crisis by Adair Turner, the chairman of the UK Financial Services Authority, recommended mandatory registration and supervision of credit rating agencies in order to manage conflicts of interest, promote good governance and ensure that credit ratings are appropriately applied. The UK Treasury, acknowledging in its July 2009 publication, ‘Reforming Financial Markets,’ that investors frequently failed to carry out sufficient due diligence and relied too much on credit rating agency assessments, agreed with Turner’s March 2009 recommendations and indicated that the UK government was working with the European Union and international partners on these issues.

The European Commission believes that the credit rating agencies failed investors in a number of ways. Such failures included the failure to reflect the worsening market conditions in their ratings early enough and the failure to timely adjust credit ratings in the deepening market crisis.  The European Commission has therefore been vigilant in pursuing rating agency regulation to address measures such as conflicts of interest, transparency, governance and quality of credit ratings and in an April 2009 press release stated that it believed that its new Regulation on Credit Rating Agencies will help give investors the information, integrity and impartiality they need from credit rating agencies and put users of credit ratings in the EU in a better position to decide if the opinions of a specific credit rating agency are trustworthy and to what extent those opinions should impact their investment choices. 

The new EU Regulation, Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 on Credit Rating Agencies, became effective on 7 December 2009 and includes requirements that are similar to the US regulations already in place as a result of the US Credit Rating Agency Reform Act of 2006, SEC actions and to the Accountability and Transparency in Rating Agencies Act of 2009 pending in the US Senate.

The EU Regulation requires mandatory registration of all credit rating agencies whose ratings are used by credit institutions and other entities for regulatory purposes and the publication of annual transparency reports detailing topics including governance structure, analyst rotation policies, internal controls and compliance reviews on their websites. 

Applications for registration may be submitted after 7 June 2010; credit rating agencies already operating in the European Community by 7 June 2010 must submit applications for registration no later than 7 September 2010.  Beginning 7 December 2010, ratings from entities not resident in the European Community and not registered pursuant to the EU Regulation will not be permitted to be used for regulatory purposes.

The regulation also requires any prospectus, published in compliance with the EU Prospectus Directive (Directive 2003/71/EC), which contains a credit rating to clearly state whether or not such ratings were issued by a credit rating agency resident in the European Community and registered pursuant to the EU Regulation on Credit Rating Agencies.

The EU Regulation seeks to minimise the effects of conflicts of interest on ratings of entities in which employees of rating agencies have ownership interests or are in positions of influence in the rated entity.  Like the US Treasury’s Sarbanes-Oxley-like proposals, the EU regulations prohibit rating agencies from providing advisory or consultancy services to a rated entity or its related third party. 

However the EU regulations do permit credit rating agencies to perform ancillary activities so long as those ancillary activities do not compromise the independence or integrity of the activities of the credit rating agency or do not create potential conflicts of interest.  Also harkening back to Sarbanes-Oxley, the EU Regulation requires rating agency employees to rotate out of teams, requiring that rating agency employees not be involved in credit rating services to any entity for any period less than two years and for no more than four years. Like the US Accountability and Transparency Act, the EU regulations require credit rating agencies to review past ratings by an ex-employee where such employee takes a position at the obligor, issuer or underwriter who had an interest in the ratings issued for that obligor, issuer or underwriter.

However, the US proposals require such a review where the employee takes up employment within one year of being involved in the rating process of its new employer, while the EU Regulation requires such a review where the new employment takes place within two years of the rating related to the new employer. The EU Regulation goes even further by prohibiting any employee directly involved in the credit rating process from taking up key management positions at a rated entity or its related third party prior to the expiration of six months from the issuance of a related credit rating.

Similarly to the SEC’s February 2009 regulations, credit rating agencies in the EU will be required to publish rating action data, as well as methodologies, models and key rating assumptions and are prohibited from making recommendations or proposals regarding the design of structured financial instruments on which the credit rating agency expects to issue a rating and from receiving gifts or favours from anyone with whom the credit rating agency does business.

Credit rating agency employees directly involved in the rating process are required not be involved in any fee negotiations with any party related to the subject of the rating process.  Both the Accountability and Transparency Act and the EU Regulation require separate categories of ratings for structured finance instruments and disclosure on the effects of changes in methodologies, models and assumptions on ratings and the use of third party due diligence services.  And like the September 2009 SEC rules, unsolicited ratings will be permitted, but they must be identified as such.

Conclusion

As mentioned above, a number of the provisions in both the EU regulation and the Accountability and Transparency Act are reminiscent of the US Sarbanes-Oxley Act of 2002, such as the conflict of interest provisions, which provided for separation of accounting firms’ audit and consultancy functions.

The annual report certification provisions in the Accountability and Transparency Act are also are reminiscent of the certification provisions of the Sarbanes-Oxley Act.  Just as the Sarbanes-Oxley Act sought to restore investor confidence in corporate America in the aftermath of the collapse of Enron due to accounting irregularities, the European Union and the US, through their respective legislative and regulatory actions seek to do the same while at the same time giving investors more tools to be able to make more independent and informed decisions in the future by mandating the publication of assumptions and methodologies behind the ratings of securities that they seek to purchase.

In the meantime, the assault on the credit rating agencies’ past actions continue with not just the New York and California court cases discussed above, but also individual state government actions against credit rating agencies like the investigation, launched in September 2009, by the Attorney General of the State of California, into credit rating agencies’ roles in the fuelling the financial crisis , the aforementioned November 2009 lawsuit instituted by the Attorney General of the State of Ohio against Moody’s, Standard & Poor’s and Fitch and a March 2010 lawsuit instituted by the Attorney General of the State of Connecticut against Moody’s and Standard & Poor’s for, as stated in an accompanying press release, knowingly assigning tainted ratings to risky investments backed by subprime loans.

What do these court, legislative and regulatory actions taken together mean from an investor’s point of view?  Among other things, it means that the opinion in New York case has opened the door to a potential onslaught of litigation from investors who have lost money by investing in mortgage-backed securities previously awarded high investment grade ratings by credit rating agencies.

It also means that if the US Senate passes the Accountability and Transparency in Rating Agencies Act of 2009 and President Obama signs it into law, the Act, along with the EU’s Regulation on Rating Agencies, will usher in a period of imposed greater disclosure requirements, supervision and liability for credit rating agencies on a global scale.

The enhanced liability provisions of the Accountability and Transparency in ratings Act may yet be considered abhorrent to First Amendment’s free speech principles and therefore subject to constitutional challenges.  Nevertheless, the enhanced disclosure provisions of both the EU Regulation and the pending US legislation will impose greater accountability on investors for their investment decisions as they would become privy pretty much to the same information that the credit rating agencies would use in the course of their rating actions.

It also means that any doors open in the US as a result of court actions like the Abu Dhabi case in New York could just as quickly be shut as the greater amount of information that would be disseminated to investors or become publicly available as a result of the new regulatory actions will mean that investors will not be able to rely on the public versus private distribution loophole in any potential future lawsuits.

In sum, these actions mean that it is advisable for investors to review their investment criteria. Just like the US Congress is re-evaluating the privileged status given to some rating agencies and removing references to ratings and rating agencies from various statutes where such references appear or demoting them from “nationally recognised statistical rating organisations” to “nationally registered statistical rating organisations”.

To remove implications that these rating entities have any national seal of approval and encourage investors to use their judgment rather than rely on rating agencies, it is advisable for investors to re-evaluate the weight given to ratings, what portions of their portfolios should contain rating agency securities, if applicable, and how they use ratings in other ways.