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Credit Rating
Agencies
Public and Private Uses of Credit Ratings
Christopher C. Nicholls
May 25, 2005
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Four topics of investigation
Public (legislative and regulatory) uses of creditratings
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
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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) at101 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 CentralBank, June 2004) at 9.
2004 AMF Report on Rating Agencies (January 2005) at 37 ff.
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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)
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Critical role of credit-rating agencies hasrecently led to:
Proposed Exchange Act Rule 3b-10 (re: “NRSRO’s”)
Proposes defining “NRSRO” in terms of 3 components:
Free Public Availability/Current Assessments ofCreditworthiness
Market Acceptance Systematic Procedures (reliability, manage conflicts, prevent
misuse of confidential information) and Adequate Resources
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Suggestions in the U.S. that legislativeauthority 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)
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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 (SeeCovitz & 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
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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 orapproved/recognized credit/bond ratingagency is used
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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
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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
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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 prefshare 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 (definitionof “money market funds” and s. 15.3(5),(6))
Proposed NI 45-106, registration and prospectus exemption forcommercial paper (NI 45-106, s. 2.36(1), (2))
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“…[credit] ratings form part of the
statutory framework of provincialsecurities legislation…” National Policy 51-201, s. 3.3(7)
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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 todowngrade? Disclosure issues (In US-Reg FD exemption)
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Ratings Triggers
Issue Studied by CRA’s, see, e.g.:
“The Unintended Consequences of Ratings Triggers”(2001)(Pamela Stumpp (Moody’s) )
"Moody's Analysis of US Corporate Rating Triggers HeightensNeed for Increased Disclosure“ (2002)
“Identifying Rating Triggers and Other Contingent Calls onLiquidity”(2002) (Solomon Samson (S & P) )
“Few European Firms Hang at Credit Cliff” (2002) (S&P)
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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
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Liquidity Implications
Reporting issuers must disclose in liquidityportion of M D & A, ratings triggers that
could “trigger an additional fundingrequirement or early payment” or that
“could impair your company’s ability to
undertake transactions” Form 51-102 F1, Part 2, item 1.6, instruction (ii)
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Other Triggers
Other triggers—such as those affectingpricing—might not be required to be
disclosed in M D & A and yet may, inaggregate, be material to an issuer
Not just downgrades that may adverselyafffect issuers
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Potential Civil Liability for CRAs
Two principal potential sources of liability:
Action brought by rated issuer
Action brought by third party users of ratings
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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 moreconservative in their ratings decisions
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Liability to Third Parties
Risk of Liability for CRAs to third partyusers of ratings is low
Under securities laws, CRA’s largely
insulated from statutory civil liability (e.g.,
Ontario Securities Act s. 130)
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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 ofindeterminate liability negatives duty under secondstage (Hercules Mangements)
Even if possible liability under Anns/Kamloops , CRAstypically responsibility (Hedley Byrne)
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Alternatives to Credit Ratings
From SEC Concept Release 33-8326: Allow the use of internally-developed credit ratings (by broker-
dealers) (Conflicts?) Industry SRO’s 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 asinvestor sophistication, denomination size, and (in case of ABSdeals) specified asset and structure experience criteria
Coverage Ratios?
Credit Spreads?
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Alternatives to Credit Ratings
Private contracts: If market regarded alternativesas superior to credit ratings, alternatives wouldbe used
Regulatory uses: Alternatives such as creditspreads may not be an adequate substitute forcredit ratings because:
Too volatile—too many “false negatives”? [Stability isvalued for credit ratings] Information asymmetry
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Conclusion
Public and private uses of credit ratings are useful, no superior alternative to creditratings for these purposes exists, and such use should not be discouraged
Legislative and regulatory use of credit ratings originally simply a reflection of marketreality, but now impacts the market
CRAs fundamentally different from registrants
Regulation through control of designation—with only sanction a removal ofdesignation—places regulator in relationship with CRA similar to CRA’s relationshipto 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 BISpurposes, unlikely that Canadian regulators can (or should) act unilaterally.
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