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Bunjevac, Tin A --- "Credit Rating Agencies: A Regulatory Challenge for Australia" [2009] MelbULawRw 2; (2009) 33(1) Melbourne University Law Review 39

[*] BA, LLB (Melb); Member of the Victorian Bar; Lecturer of Comparative Corporate Law, Victoria Law School, Victoria University. Email <tin.bunjevac@gmail.com>.

[1] According to the International Monetary Fund, the 2007–08 credit crisis was ‘the largest financial shock since the Great Depression’: International Monetary Fund, World Economic Outlook: April 2008 Housing and the Business Cycle (2008) 4. See also George Soros, Statement to Committee on Oversight and Government Reform, US House of Representatives, Hedge Funds and the Financial Market, 13 November 2008, 3. It resulted in the disappearances of prominent Wall Street investment firms and banks such as The Bear Stearns Companies and Lehman Brothers Holdings, whilst the remaining investment banks such as Goldman Sachs have turned themselves into deposit-taking institutions with all the regulatory consequences that follow: see Julie Creswell and Ben White, ‘Wall Street, RIP: The End of an Era, Even at Goldman’, Business, The New York Times (New York), 28 September 2008, 1.

[2] This paper uses the term CRAs to refer to credit rating agencies in general and the main three CRAs in particular, given that these CRAs rate almost 100 per cent of all public debt in Australia and internationally. These are Standard & Poor’s (‘S&P’), Moody’s Investors Service (‘Moody’s’), and Fitch Ratings (‘Fitch’): see Frank Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’ in Yasuyuki Fuchita and Robert E Litan (eds), Financial Gatekeepers: Can They Protect Investors? (2006) 59, 61; John Patrick Hunt, ‘Credit Rating Agencies and the “Worldwide Credit Crisis”: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement’ [2009] Columbia Business Law Review 109, 114–15; Sean J Egan, Testimony to the Committee on Oversight and Government Reform, US House of Representatives, Credit Rating Agencies and the Financial Crisis, 22 October 2008, 1.

[3] See generally Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 60; Financial Stability Forum, Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience (2008) 32–3, 36–7 (‘Financial Stability Forum Report’).

[4] Australian Securities and Investments Commission (‘ASIC’), Credit Rating Agencies, Class Order No 03/1093, 23 December 2003, replaced by ASIC, Credit Rating Agencies, Class Order No 05/1230, 31 December 2005.

[5] European Commission, Proposal for a Regulatory Framework for CRAs (2008) 1 (‘European Commission’s Consultation Document’). The Commission describes its policy as a response to ‘the manifest failure of self-regulatory efforts, both formal and informal, to ensure high standards of independence, integrity and professional diligence.’

[6] See ibid; Financial Stability Forum Report, above n 3, 5–6, 32; Technical Committee of the International Organization of Securities Commissions (‘IOSCO’), The Role of Credit Rating Agencies in Structured Finance Markets: Final Report (2008) 2 (‘IOSCO Final Report’).

[7] Financial Stability Forum Report, above n 3, 32.

[8] Ibid 33. See also Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 76–7. See generally Frank L Raiter, Written Statement to the Committee on Oversight and Government Reform, US House of Representatives, Credit Rating Agencies and the Financial Crisis, 22 October 2008, 3–7.

[9] Financial Stability Forum Report, above n 3, 33. See also Raiter, above n 8, 4–5. According to Raiter, S&P’s quantitative assumptions were based upon very limited historical and loan pool data. He states that S&P’s models were initially built on a pool of only 500 000 loans. A subsequent version of the model was based on 900 000 loans. Two further versions of the model had been developed by 2004, with the most recent based on a pool of 9.5 million loans. Neither of these, however, were implemented due to funding constraints.

[10] Committee on the Global Financial System, Bank for International Settlements, The Role of Ratings in Structured Finance: Issues and Implications (2005) 24.

[11] Ibid 3. See also IOSCO Final Report, above n 6, 2: ‘observations relating to the market for certain structured finance instruments … raised questions about the quality of CRA ratings and the independence of the CRAs rating RMBSs and CDOs.’

[12] See Transcript of Proceedings, Committee on Oversight and Government Reform, US House of Representatives, Washington DC, 22 October 2008, 51 (Sean J Egan, Managing Director of Egan-Jones Ratings) (‘Transcript of US House Committee’). According to Egan, CRAs had been so confident that house prices would always appreciate that they devised a statistical ‘house appreciation rate’ acronym which was used in their risk valuation models. See also Soros, above n 1, 1:

The proximate cause is to be found in the housing bubble or more exactly in the excesses of the subprime mortgage market. The longer a double-digit rise in house prices lasted, the more lax the lending practices became. In the end, people could borrow 100 percent of inflated house prices with no money down. Insiders referred to subprime loans as ninja loans — no income, no job, no questions asked.

[13] See SEC, Proposed Rules for Nationally Recognized Statistical Rating Organizations, 73 Fed Reg 36 212, 36 216–17 (25 June 2008) (‘Proposed SEC Rules’). According to the SEC, the S&P delinquency rate for subprime loans was 4.97 per cent in 2005, 10.55 per cent in 2006, and 15.19 per cent in 2007: at 36 217.

[14] Ibid 36 216–17.

[15] Ibid 36 213–14, 36 216–18. For example, Fitch issued downgrades to approximately 30 per cent of subprime based securities: at 36 217. See also Raiter, above n 8, 2.

[16] Jerome S Fons, Testimony to Committee on Oversight and Government Reform, US House of Representatives, Credit Rating Agencies and the Financial Crisis, 22 October 2008, 2.

[17] Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 75–6.

[18] Ibid 76–80. Partnoy states that ‘[h]owever sophisticated the techniques, they are subject to the limitations of “garbage in, garbage out”’: at 77.

[19] John C Coffee Jr, Testimony to Committee on Banking, Housing and Urban Affairs, US Senate, Turmoil in the US Credit Markets: The Role of Credit Rating Agencies, 22 April 2008, 4.

[20] See Financial Stability Forum Report, above n 3, 33, 36–7; IOSCO Final Report, above n 6, 9; ibid 3–4.

[21] Fons, Testimony to Committee on Oversight and Government Reform, above n 16, 2.

[22] Ibid. See also SEC, Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies (2008) 9 (‘SEC Examination’); Financial Stability Forum Report, above n 3, 37; Raiter, above n 8, 7. According to the SEC, the CRAs’ analyses were based primarily on the credit rating of each RMBS or CDO in the underlying pool and did not include an analysis of the underlying assets in those instruments.

[23] Coffee, above n 19, 9.

[24] Ibid. See also Financial Stability Forum Report, above n 3, 33, 36–8. One of the reasons for the lack of interest in the securities lies in the originate-to-distribute nature of the securities, whereby the issuers were interested in quick repackaging and sales of the securities: at 8–10; IOSCO Final Report, above n 6, 5.

[25] Fons, Testimony to Committee on Oversight and Government Reform, above n 16, 2; Committee of European Securities Regulators (‘CESR’), The Role of the Credit Rating Agencies in Structured Finance (Consultation Paper No 08-036, 2008) 8, 10.

[26] See IOSCO Final Report, above n 6, 7–8; Raiter, above n 8, 6.

[27] Soros, above n 1, 7.

[28] IOSCO Final Report, above n 6, 7–8. See also Soros, above n 1, 7.

[29] Gary Gorton, ‘The Subprime Panic’ (Working Paper No 08-25, International Center for Finance, Yale School of Management, 2008) 26–7 <http://ssrn.com/abstract=1276047> .

[30] Ibid 27. See also Soros, above n 1, 7.

[31] Fons, Testimony to Committee on Oversight and Government Reform, above n 16, 2; IOSCO Final Report, above n 6, 8.

[32] IOSCO Final Report, above n 6, 8. See also Financial Stability Forum Report, above n 3, 34.

[33] IOSCO Final Report, above n 6, 8.

[34] See Committee on the Global Financial System, above n 10, 22, 40. Several reasons were identified for investor reliance, including: ‘the rating agencies’ role in modelling the risks of complex structured finance instruments; their key role in deal structuring; and [their] clear information advantage, in particular over less sophisticated investors’: at 40. The Committee noted that ‘[a] number of investors … claim to rely almost exclusively on the rating agencies’ pre-sale reports and rating opinions for information on deal specifics and performance’: at 23.

[35] Amélie Champsaur, ‘The Regulation of Credit Rating Agencies in the US and the EU: Recent Initiatives and Proposals’ (LLM Thesis, Harvard University, 2005) 19–20 <http://www.law.harvard.edu/programs/pifs/pdfs/amelie_champasaur.pdf> .

[36] Ibid 22–3. See generally Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 60–1, 81–3.

[37] Champsaur, above n 35, 23–4. This issue has also been analysed in detail by Partnoy: Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 81–3; Frank Partnoy, ‘The Siskel and Ebert of Financial Markets? Two Thumbs Down for the Credit Ratings Agencies’ (1999) 77 Washington University Law Quarterly 619, 681–703.

[38] Champsaur, above n 35, 22.

[39] Ibid.

[40] Ibid 23.

[41] Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 82–3. See Adam Creighton, Luke Gower and Anthony Richards, ‘The Impact of Rating Changes in Australian Financial Markets’ (Research Discussion Paper No 2004-02, Reserve Bank of Australia, 2004) 2:

For example, the Investment Company Act of 1940 [and 17 CFR 270.2a-7(a)(10)(i) (2008)] requires that money market funds invest only in securities rated in the two highest categories. The investment grade distinction is also important in the Federal Deposit Insurance Act [12 USC § 1831e(d)(4)(A) (2006)], where corporate debt is only ‘investment grade’ if rated in one of the four highest categories.

[42] Champsaur, above n 35, 35.

[43] Michael Cole, Review of NSW Local Government Investments: Final Report (2008) 14. Cole estimates that local councils in New South Wales alone have suffered losses of approximately A$320 million on their investment portfolios linked to subprime CDOs.

[44] Martin Gold, ‘Financial Sustainability and the Imperative for Reform in Investment Organisation in Australia’s Local Government Sector’ (2008) 14 Journal of Accounting, Accountability and Performance 35, 46–7, 56. According to Gold, a notable feature of investment policies which apply in the local government sector in Victoria and NSW is the use of credit ratings to develop approved lists for short-term and long-term debt issues. Councils in Victoria and NSW are required to consider specific objectives prior to investing, such as risk and return, liquidity, diversification, as well as a prescriptive list with minimum credit ratings for short-term and long-term debt securities: Local Government Act 1989 (Vic) s 143; Department of Treasury and Finance (Vic), Prudential Statement on Investment Powers of Councils (1998); Local Government Act 1993 (NSW) s 625(2); Minister for Local Government (NSW), ‘Local Government Act 1993 — Investment Order (Relating to Investments by Councils)’ in New South Wales, Government Gazette, No 97, 15 August 2008, 7638.

[45] Creighton, Gower and Richards, above n 41, 2. According to the authors, there are a number of public finance areas in which CRA ratings are explicitly used. For example (at fn 3):

General insurers can use credit ratings to determine counterparty risk weightings …; mortgage insurers must be rated at least ‘A’ for Authorised Deposit-taking Institutions (ADIs) to receive a concessional risk weighting for insured mortgages …; and, ratings are one of the criteria for determining whether certificates of deposit and bank bills can be categorised as ‘high quality liquid assets’ …

[46] See Australian Prudential Regulation Authority (‘APRA’), Guidelines on Recognition of an External Credit Assessment Institution (2008) 12–13 (‘APRA Guidelines’). Australia has agreed to implement the Basel II Framework of the Basel Committee on Banking Supervision, which allows banking institutions to use credit ratings from CRAs, called External Credit Assessment Institutions (‘ECAIs’), when calculating their net capital reserves: at 3. See also APRA, ‘Implementation of Basel II in Australia’ (Press Release, 3 November 2004); Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards: A Revised Framework Comprehensive Version (2006).

[47] Geoff Anderson, ‘Standard Bearers for the Markets: International Credit Rating Agencies, New Actors in Politics and Public Policy’ (Paper presented at the Australasian Political Studies Association Conference, Adelaide, 29 September – 1 October 2004) 4. In this paper, Anderson explains the process of CRAs’ integration into the broader regulatory structure of public administration in Australia and the means by which the requirements of global financial markets were transmitted to the public sector.

[48] See generally Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 90–1; Coffee, above n 19, 1, 17.

[49] Catherine Lubochinsky and Olivier Raingeard, ‘Comments on the Proposal for a Directive/Regulation of the European Parliament and of the Council on Credit Rating Agencies’, Submission to the European Commission, Consultation on Policy Proposals regarding Credit Rating Agencies, 5 September 2008, 8–9. According to Lubochinsky and Raingeard, the SEC did not disclose applications for recognition as an NRSRO and did not define the planning processes used for its decisions. They cite the example of the Lace Financial Corporation application, which took eight years to process: at 9. See also Financial Stability Forum Report, above n 3, 38.

[50] Lubochinsky and Raingeard, above n 49, 8–9. Lubochinsky and Raingeard refer to S&P’s Corporate Ratings Criteria in which S&P admits that it rates 99.2 per cent of the debt obligations and preferred stock issues in the US: at 9.

[51] Pub L No 109-291, 120 Stat 1327.

[52] See IOSCO Final Report, above n 6, 8–9.

[53] Lubochinsky and Raingeard, above n 49, 10.

[54] Ibid 13–14. Lubochinsky and Raingeard recommend the approach in Committee of European Banking Supervisors, Guidelines on the Recognition of External Credit Assessment Institutions (2006), which takes into account CRAs’ relative and absolute performance, their rating ‘power curve’, their average rating prior to default, a comparison of stability of the ratings based on those measures, and a comparison of the rating differences.

[55] Securities Exchange Act of 1934, 15 USC § 78o-7(a)(1)(B)(ii) (2006), as amended by CRA Reform Act § 4(a).

[56] European Commission, Proposal for a Regulation of the European Parliament and of the Council on Credit Rating Agencies (2008) art 7. The proposal has been sent to the EU Parliament and Council for adoption. See also Proposed SEC Rules, above n 13, 36 233, in which the SEC proposes modifications to Securities Exchange Act of 1934, 15 USC § 78o-7(a)(1)(B)(ii) (2006), requiring enhanced disclosure of rating methodologies and verification of loan pool data.

[57] See EU Proposal, above n 56, art 9, annex I sections D(II)(1), E(I). The EU Proposal provides that ‘[w]here a credit rating agency rates a structured finance instrument, it shall provide in the credit rating information about loss and cash flow analysis it has performed’: at annex I section D(II)(1).

[58] APRA Guidelines, above n 46, 5. Annex 4 provides (at 12) that:

(1) APRA … will review:

    (a) the size and the scope of the pool of issuers the ECAI covers;

    (b) the range and meaning of the credit assessments that it assigns;

    (c) the statistical significance of the ECAI’s default rates; and

    (d) the definition of default used by the ECAI.

(2) In addition to the qualitative factors outlined above, APRA will also have regard to other relevant factors such as:

    (a) the variable used to weigh default events;

    (b) geographical coverage; and

    (c) dynamic properties and characteristics of the ratings system or methodology.

[59] Ibid 11.

[60] See, eg, the matters listed by Creighton, Gower and Richards: see above n 45.

[61] SEC, References to Ratings of Nationally Recognized Statistical Rating Organizations, 73 Fed Reg 40 088, 40 089 (11 July 2008).

[62] Frank Partnoy, Submission to SEC, References to Ratings of Nationally Recognized Statistical Rating Organizations, 5 September 2008, 1.

[63] See, eg, Transcript of US House Committee, above n 12, 76 (Frank L Raiter).

[64] Ibid.

[65] Steven L Schwarcz, ‘Private Ordering of Public Markets: The Rating Agency Paradox’ [2002] University of Illinois Law Review 1, 15.

[66] Ibid 13. Schwarcz cites a 1991 article, which states ‘that in 20 years only one company with an investment-grade rating from Moody’s ha[d] defaulted on long-term debt’: ‘Beyond the Second Opinion: Credit Rating Agencies’, The Economist (London), 30 March 1991, 80.

[67] See Proposed SEC Rules, above n 13, 36 217. According to the SEC, the magnitude of the downgrades was ‘striking’ and ‘unprecedented’. The average downgrade was around seven notches whereas the previous average, prior to 2007, was three to four notches. See also Henry A Waxman, Statement to Committee on Oversight and Government Reform, US House of Representatives, Credit Rating Agencies and the Financial Crisis, 22 October 2008, 1. According to Waxman: ‘S&P … downgraded more than two-thirds of its investment-grade [structured finance] ratings. Moody’s had to downgrade over 5000 mortgage-backed securities.’

[68] Hunt, above n 2, 161.

[69] Ibid 164–73.

[70] Ibid.

[71] Committee on Oversight and Government Reform, US House of Representatives, Revenue of Big 3 Credit Rating Agencies: 2002–2007 (2008) <http://oversight.house.gov/story.asp?ID=2250> .

[72] Joseph R Mason and Joshua Rosner, ‘Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions’ (Working Paper, 3 May 2007) 13 <http://ssrn.com/abstract=1027475> Timothy J Riddiough and Risharng Chiang, Commercial Mortgage-Backed Securities: An Exploration into Agency, Innovation, Information, and Learning in Financial Markets (2004) 1 <http://www.fin.nchu.edu.tw/03_research/fin2003/Commercial%20Mortgage-backed%20Securities.pdf> CESR, The Role of the Credit Rating Agencies in Structured Finance, above n 25, 9; Hunt, above n 2, 176–8. According to Riddiough and Chiang, ‘the rating agency actively controls security architecture and [is] instrumental in determining product design standards.’ See also Committee on the Global Financial System, above n 10, 2:

deal origination … involves obtaining implicit structuring advice by the rating agencies, at least to the extent that arrangers use rating agency models to pre-structure deals and subsequently engage in an iterative dialogue with the agencies in order to finalise these structures.

The Committee further stated (at 26):

in contrast to the truly ancillary nature of the consulting services that were provided by a number of auditors, the assessment of transactions’ structural features is an integral part of the process of rating structured finance tranches.

[73] Mason and Rosner, above n 72, 13; Jerome S Fons, ‘Rating Competition and Structured Finance’ (2008) 14(3) Journal of Structured Finance 7, 11; Coffee, above n 19, 78–80.

[74] Fons, ‘Rating Competition and Structured Finance’, above n 73, 11.

[75] Ibid. Fons states that ‘structured finance is perhaps the largest single product line for the major ratings agencies, representing 40 per cent or more of total revenues.’ See also Waxman, above n 67, 1:

total revenues for the three firms doubled from $3 billion in 2002 to over $6 billion in 2007. At Moody’s, profits quadrupled between 2000 and 2007. In fact, Moody’s had the highest profit margin of any company in the S&P 500 for five years in a row.

[76] Fons, ‘Rating Competition and Structured Finance’, above n 73, 11.

[77] Ibid. See also Raymond McDaniel, ‘Credit Policy Issues at Moody’s Suggested by the Subprime/Liquidity Crisis’ (21 October 2007) [9] <http://oversight.house.gov/documents/20081022111050.pdf> : ‘The [CDO ratings] are simply the latest instance of trying to hit perfect rating pitch in a noisy market place of competing interests.’

[78] Lubochinsky and Raingeard, above n 49, 5; IOSCO Final Report, above n 6, 14. See also Mason and Rosner, above n 72, 13.

[79] McDaniel, above n 77, [12]–[13]: ‘a certain complacency about ratings quality is inevitable after a prolonged period of rating success. … Organizations often interpret past successes as evidencing their competence and the adequacy of their procedures rather than a run of good luck.’

[80] Ibid [10].

[81] Ibid [5].

[82] Ibid [10]. According to McDaniel, ‘[a]nalysts and [managing directors] are continually “pitched” by bankers, issuers, investors — all with reasonable arguments — whose views can colour credit judgment, sometimes improving it, other times degrading it’.

[83] Moody’s Investors Service, ‘Final Transcript: Managing Director’s Town Hall Meeting’ (10 September 2007) 63 <http://oversight.house.gov/story.asp?ID=2250> . McDaniel states:

What happened in ’04 and ’05 with respect to subordinated tranches is that our competition, Fitch and S&P, went nuts. Everything was investment grade. … We said we’re not rating it. This stuff isn’t investment grade. No one cared because the machine just kept going.

[84] SEC Examination, above n 22.

[85] CRA Reform Act § 5, amending 15 USC § 78q(a)(1) (2006).

[86] SEC Examination, above n 22, 9.

[87] Ibid 18.

[88] Ibid 10.

[89] Ibid 12. The SEC lists a number of examples of staff awareness of model deficiencies. For instance ‘[o]ne analyst expressed concern that her firm’s model did not capture “half” of the deal’s risk, and that “it could be structured by cows and [the CRA] would rate it.”’

[90] Ibid 13.

[91] Ibid.

[92] Ibid 14.

[93] Ibid.

[94] Ibid 16–17.

[95] Ibid 19–20.

[96] Ibid 19.

[97] Ibid 21.

[98] Ibid.

[99] See Transcript of US House Committee, above n 12, 40.

[100] Ibid 40–1.

[101] Ibid.

[102] SEC Examination, above n 22, 23.

[103] See, eg, Corporate Law Economic Reform Program, Corporate Disclosure: Strengthening the Financial Reporting Framework, Paper No 9 (2002) pt 7.2 (‘CLERP 9’):

The way analysts are compensated for the services they provide can create pressure on their independence and objectivity. A research analyst’s salary or bonus might be linked to the profitability of other corporate and trading services, such as investment banking services. This might give the analyst an incentive to provide positive research reports and recommendations, which may foster the client company’s continued relationship with the analyst’s firm and increase the analyst’s compensation.

[104] SEC Examination, above n 22, 23–4. See also CESR, The Role of the Credit Rating Agencies in Structured Finance, above n 25, 9, 13.

[105] SEC Examination, above n 22, 24–5.

[106] Ibid 25–6.

[107] Ibid 31.

[108] CESR, The Role of the Credit Rating Agencies in Structured Finance, above n 25, 9.

[109] SEC Examination, above n 22, 32. See also ibid 13.

[110] See above Part III(A).

[111] SEC Examination, above n 22, 31–2. The term ‘churning’ refers to the situation where the issuer’s staff is eager to achieve a large volume of transactions to get bonuses and commissions. They put pressure on the rating staff which affects CRAs’ rating performance.

[112] Ibid 8, 31. See also CESR, The Role of the Credit Rating Agencies in Structured Finance, above n 25, 9, 21; Committee on the Global Financial System, above n 10, 26.

[113] Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 68–71; Mason and Rosner, above n 72, 19.

[114] Coffee, above n 19, 16. See also Fons, ‘Rating Competition and Structured Finance’, above n 73, 11.

[115] Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 70. See also CESR, The Role of the Credit Rating Agencies in Structured Finance, above n 25, 12.

[116] Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 70; Stephen J Choi, ‘A Framework for the Regulation of Securities Market Intermediaries’ (2004) 1 Berkeley Business Law Journal 45, 51–2. Choi refers to Enron-type conflicts involving the auditing firm Arthur Andersen: at 52–3.

[117] Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 72.

[118] Ibid 71–2. Partnoy discusses one case when Moody’s issued a ‘negative outlook’ on the bonds of a former client, a school district, which hired S&P and Fitch for the issue. Several buyers immediately cancelled their orders and the school district was forced to re-price the bonds and pay a higher rate. See also Transcript of US House Committee, above n 12, 65–7, in which Sean Egan referred to an adverse unsolicited rating issued by Moody’s when the German insurer Hannover Re refused to be rated by them. A Committee member characterised the practice as ‘a form of a racket’: at 65 (Dennis Kucinich).

[119] Egan, above n 2, 1.

[120] Ibid 3; Fons, Testimony to Committee on Oversight and Government Reform, above n 16, 3–4. See also Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 63. Fons and Partnoy point out that the agency John Moody founded was an investors’ service, rather than an issuers’ service.

[121] See Transcript of US House Committee, above n 12, 28. According to Egan, Egan-Jones Ratings downgraded Enron Corporation several months before the competitors and WorldCom nine months before.

[122] Fons, ‘Rating Competition and Structured Finance’, above n 73, 12.

[123] Ibid.

[124] Deven Sharma, Testimony to Committee on Oversight and Government Reform, US House of Representatives, Credit Rating Agencies and the Financial Crisis, 22 October 2008, 12.

[125] Fons, ‘Rating Competition and Structured Finance’, above n 73, 12; ibid 11.

[126] Sharma, above n 124, 11.

[127] See Fons, ‘Rating Competition and Structured Finance’, above n 73, 12–13. Fons also discusses a theoretical ‘Mutual Rating Organization’ funded by all industry participants. However, he acknowledges the market, institutional and regulatory constraints in establishing such a structure.

[128] Choi, above n 116, 70–1.

[129] Ibid 70.

[130] Ibid 49, 51.

[131] Ibid 50.

[132] IOSCO Final Report, above n 6, annex A (‘IOSCO Code’), which was preceded by IOSCO, Code of Conduct Fundamentals for Credit Rating Agencies (2004). See also CESR, CESR’s Second Report to the European Commission on the Compliance of Credit Rating Agencies with the IOSCO Code and the Role of Credit Rating Agencies in Structured Finance (2008). The CESR provides a long list of areas where the CRAs did not comply with the IOSCO Code. They conclude that ‘[t]his non-compliance, even though there are explanations, indicates that some of the issues which the IOSCO Code is intended to address, are not being managed through the CRAs Codes in a manner that matches the IOSCO Code provisions exactly’: at 51.

[133] Choi, above n 116, 71, 75.

[134] See above Part II(D).

[135] Partnoy, ‘How and Why Credit Rating Agencies Are Not Like Other Gatekeepers’, above n 2, 60.

[136] See Choi, above n 116, 72–3.

[137] Pub L No 107-204, § 101, 116 Stat 745, 750–3 (2002), inserting 15 USC § 7211 (2006). See also ibid 73–4.

[138] Pub L No 107-204, § 201, 116 Stat 745, 771 (2002), inserting 15 USC § 78j-1(g) (2006). See generally Choi, above n 116, 60–3.

[139] Pub L No 107-204, § 203, 116 Stat 745, 773 (2002), inserting 15 USC § 78j-1(j) (2006).

[140] Pub L No 107-204, §§ 301, 404, 116 Stat 745, 775, 789 (2002), inserting 15 USC §§ 78j-1(j), 7262 (2006).

[141] Larry E Rittenberg and Patricia K Miller, Sarbanes-Oxley Section 404 Work: Looking at the Benefits (2005) 2. The study was conducted on behalf of the American Institute of Internal Auditors Research Foundation. Rittenberg and Miller found general improvements in audit committees and in senior management engagement in financial reporting and controls: at 2, 10.

[142] See EU Proposal, above n 56.

[143] Ibid art 5, annex 1 sections A(1)–(2).

[144] Ibid annex 1 section A(2).

[145] Ibid. The relevant passage provides that:

In addition to the overall responsibility of the board, the independent members of [the] administrative or supervisory board shall have the specific task of monitoring the development of the credit rating policy, the effectiveness of the internal quality control system of the credit rating agency on the credit rating process to ensure that there are no conflicts of interest and the compliance and governance processes including the efficiency of the review function referred to in point 7 of this Section.

[146] Eliot Spitzer, ‘SEC, NY Attorney-General, NASD, NASAA, NYSE and State Regulators Announce Historic Agreement to Reform Investment Practices’ (Press Release, 20 December 2002). See generally Choi, above n 116, 66–7.

[147] Andrew M Cuomo, ‘Attorney-General Cuomo Announces Landmark Reform Agreements with the Nation’s Three Principal Credit Rating Agencies’ (Press Release, 5 June 2008).

[148] Ibid.

[149] Proposed SEC Rules, above n 13, 36 218–19, amending 17 CFR § 240.17g-5(b) (2008).

[150] 17 CFR §§ 240.17g-5(b)(1), (3)–(6) (2008). Other manageable conflicts include non-arms-length associations with issuers, as well as ratings of broker-dealers who are engaged in the business of underwriting securities: see §§ 240.17g-5(b)(1), (7)–(9) (2008).

[151] See Proposed SEC Rules, above n 13, 36 219, amending 17 CFR § 240.17g-5(a) (2008).

[152] Proposed SEC Rules, above n 13, 36 219–20, amending 17 CFR § 240.17g-5(a) (2008). According to the SEC, this requirement would include information used in rating and surveillance about the assets underlying the security and the legal structure, but would exclude specific information about the underlying loan pool data as well as certain communications between the CRAs and the issuers.

[153] Proposed SEC Rules, above n 13, 36 233, amending the instructions for Exhibit 2 to

Form NRSRO (the form prescribed by 17 CFR § 249b.300 (2008) to be used in an initial application for registration as an NRSRO), thereby altering the application process for registration under 15 USC § 78o-7(a)(1)(B)(ii) (2006). The SEC is proposing to require that both an applicant and an existing NRSRO provide this information in their description of procedures and methodologies in Exhibit 2.

[154] 17 CFR §§ 240.17g-5(c)(1)–(4) (2008).

[155] See Proposed SEC Rules, above n 13, 36 226, amending 17 CFR § 240.17g-5(c) (2008).

[156] Proposed SEC Rules, above n 13, 36 227, amending 17 CFR § 240.17g-5(c) (2008). For similar corresponding provisions relating to employees, see EU Proposal, above n 56, art 6, annex I section C(4).

[157] Lubochinsky and Raingeard, above n 49, 15.

[158] EU Proposal, above n 56, art 9(3), annex I section E(II)(2).

[159] See Proposed SEC Rules, above n 13, 36 231, amending 17 CFR § 240.17g-2(b)(7) (2008).

[160] See Proposed SEC Rules, above n 13, 36 228–30, amending 17 CFR §§ 240.17g-2(a)(2), (a)(8), (d) (2008).

[161] Proposed SEC Rules, above n 13, 36 235, inserting 17 CFR § 240.17g-7 (2008); EU Proposal, above n 56, art 8(3).

[162] Proposed SEC Rules, above n 13, 36 235.

[163] EU Proposal, above n 56, art 8(5).

[164] Ibid art 5(2), annex I section B(4). Notably, the Commission made a distinction between advisory and ancillary services. CRAs are allowed to provide ancillary services, which must be defined and disclosed. For the requirements relating to disclosure, see art 9(1), annex I section E(I)(2).

[165] Ibid art 9(2).

[166] Ibid art 5, annex I section A.

[167] Ibid arts 6(4)–(5). Note that this requirement only applies to CRAs who have 50 or more analysts.

[168] For example, art 5 seeks to ensure the independence of ratings by requiring CRAs to prevent conflicts of interest or manage them adequately where they are unavoidable. Furthermore, annex I section B contains operational measures, section C contains rules about employee independence and section D contains rules on the representation of credit ratings.

[169] Ibid art 10, annex I section E(III).

[170] Ibid art 6, annex I section C, which provide an exhaustive list of rules about analyst independence. These are substantially similar to those proposed by the SEC: see Proposed SEC Rules, above n 13, 36 226–8.

[171] Ibid art 8(2), annex I section D(II)(2).

[172] See, eg, IOSCO Code art 1.2: ‘A CRA should use rating methodologies that are rigorous, systematic, and, where possible, result in ratings that can be subjected to some form of objective validation based on historical experience.’ Further, art 1.7-3 provides:

A CRA should assess whether existing methodologies and models for determining credit ratings of structured products are appropriate when the risk characteristics of the assets underlying a structured product change materially. In cases where the complexity or structure of a new type of structured product or the lack of robust data about the assets underlying the structured product raise serious questions as to whether the CRA can determine a credible credit rating for the security, [the] CRA should refrain from issuing a credit rating.

[173] Ibid art 1.9: ‘A CRA should ensure that adequate personnel and financial resources are allocated to monitoring and updating its ratings.’

[174] Ibid art 1.13: ‘A CRA’s analysts should be held to high standards of integrity, and a CRA should not employ individuals with demonstrably compromised integrity.’ See also art 1.14-1: ‘[a] CRA should prohibit its analysts from making proposals or recommendations regarding the design of structured finance products that a CRA rates.’

[175] Ibid art 2.2: ‘A CRA and its analysts should use care and professional judgment to maintain both the substance and appearance of independence and objectivity.’

[176] Ibid art 2.1: ‘A CRA should not forbear or refrain from taking a rating action based on the potential effect (economic, political, or otherwise) of the action on the CRA, an issuer, an investor, or other market participant.’ See also art 2.4, which provides that ‘[t]he credit rating a CRA assigns to an issuer or security should not be affected by the existence of or potential for a business relationship between the CRA … and the issuer … or any other party’. See also art 2.5:

A CRA should separate, operationally and legally, its credit rating business and CRA analysts from any other businesses of the CRA, including consulting businesses, that may present a conflict of interest. A CRA should ensure that ancillary business operations which do not necessarily present conflicts of interest with the CRA’s rating business have in place procedures and mechanisms designed to minimize the likelihood that conflicts of interest will arise. A CRA should also define what it considers, and does not consider, to be an ancillary business and why.

[177] Ibid art 3.5(d):

Where a CRA rates a structured finance product, it should provide investors and/or subscribers (depending on the CRA’s business model) with sufficient information about its loss and cash-flow analysis so that an investor allowed to invest in the product can understand the basis for the CRA’s rating.

[178] European Commission’s Consultation Document, above n 5, 2.

[179] EU Proposal, above n 56, 3 (emphasis added).

[180] Ibid. This is the so-called ‘comply or explain’ approach.

[181] Ibid 9, discussing arts 12–17.

[182] Ibid art 20(3)(c).

[183] Ibid art 21.

[184] Ibid art 31.

[185] See, eg, Corporations Act 2001 (Cth) s 915B, which gives ASIC the power to suspend or cancel an Australian Financial Services Licence. Sections 920A and 921A give ASIC the power to ban or disqualify a licensee where the licensee has not complied with licence obligations. Section 912E requires licensees to cooperate with ASIC surveillance and other checks.

[186] Corporations Act 2001 (Cth) s 766B(1) defines ‘financial product advice’ as:

a recommendation or a statement of opinion, or a report of either of those things, that:

(a) is intended to influence a person or persons in making a decision in relation to a particular financial product or class of financial products, or an interest in a particular financial product or class of financial products; or

(b) could reasonably be regarded as being intended to have such an influence.

[187] See above n 4 and accompanying text.

[188] Corporations Act 2001 (Cth) s 912A(1)(a).

[189] Corporations Act 2001 (Cth) s 912A(1)(aa).

[190] Corporations Act 2001 (Cth) ss 912A(1)(d)–(j).

[191] ASIC, Credit Rating Agencies, Class Order No 05/1230, 31 December 2005; ASIC, ‘ASIC Provides Ongoing Licensing Relief for Credit Rating Agencies’ (Information Release No 05/63, 19 December 2005).

[192] ASIC, Licensing: Credit Ratings Agencies (Consultation Paper No 65, 2005) 3.

[193] Nick Sherry, ‘Minister Welcomes Roundtable Report on Ratings Users and Accepts Regulator Update on Licensing’ (Press Release, 5 June 2009). According to the release:

In late 2008, the Government announced that ratings agencies would be required to hold an Australian Financial Services Licence (AFSL) by 1 July, 2009, and issue annual compliance reports against the International Organisation of Securities Commissions (IOSCO) Code of Conduct.

ASIC has requested, and the government has agreed to, a further extension of the licensing timeframe until 1 January 2010.