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SFC Consultation on Credit Rating Agencies

Saturday, July 24, 2010
Opalesque Industry Update - Hong Kong's Securities and Futures Commission (SFC) has issued a consultation paper seeking public feedback on its proposals to introduce a regulatory regime for credit rating agencies (CRAs). The firms will be subject to licensing requirements, with their existing rating analysts grandfathered into the new regime on the basis that they "invariably are highly qualified".

However, following the apparent contribution of poor quality credit ratings to the global financial crisis, the appropriate regulatory environment for this industry is still evolving and hotly debated. Whilst the SFC's licensing proposals have been driven in large part by new European Union regulations (forcing other jurisdictions to adopt "equivalent" regulations if ratings produced by their local CRAs are to remain serviceable in Europe), recent developments in the United States could also have a significant impact on the industry worldwide.

The Dodd-Frank Act, signed into law by President Obama on 21 July 2010, includes a provision repealing immunities previously enjoyed by CRAs from liability for their opinions. The "Big Three" generally thought to own the credit rating universe – Standard & Poor's, Moody's, and Fitch – immediately reacted by prohibiting use of their ratings in new bond sales in the United States. At least until CRAs work out how to protect their interests under the new rules, this has effectively shut down some of the bond markets.

Whilst the SFC's consultation paper will clearly be of interest to the Big Three, all of which have offices in Hong Kong, it is also important for other entities to consider whether the proposals could affect their own operations. The SFC has made a worthy effort to identify activities that (without careful drafting of definitions for "credit ratings" and "providing credit rating services" in proposed amendments to the Securities and Futures Ordinance), could inadvertently be captured under the new regime.

Many organisations produce ratings that closely resemble those of traditional CRAs – such as banks' in-house assessments of counterparty risk. The SFC currently has no interest in licensing such activities, essentially on the grounds that the ratings are produced for internal purposes rather than for public consumption. Given that banks may distribute their ratings amongst group companies, however, the rating activities of banks (and others) can be difficult to distinguish from the activities of the traditional CRAs.

Similarly, the SFC's objectives do not include the creation of licensing obligations in relation to private credit ratings prepared pursuant to an individual order, the sharing or analyzing of consumer or commercial credit data (such as through consumer or commercial credit reference agencies), or the sharing or analyzing of personal consumer credit data.

The SFC has found a number of smaller CRAs, whose business models may differ significantly from those of their larger competitors. Given the overwhelming dominance of the Big Three (across the ratings industry as a whole, if not in some niche areas), it will be particularly important for smaller CRAs to ensure that the SFC has not overlooked their individual circumstances in drafting licensing requirements that will have to apply across the whole industry.

The SFC has taken the opportunity to attempt to distinguish "providing credit rating services" from "advising on securities". Issuing credit ratings has historically been considered to fall outside the definition of "advising on securities" on the basis that credit ratings are issued specifically for the purpose of indicating creditworthiness, rather than for facilitating decisions on whether securities should be acquired or disposed of. It is in the interests of issuers of credit ratings, and even of anyone involved in republication of credit ratings, to ensure that the distinction is properly achieved. Likewise, it is in the interests of persons licensed for Type 4 regulated activity (advising on securities) to ensure that the new Type 10 regulated activity (providing credit rating services) will not inadvertently capture anything that they may do, such as issuing broker recommendations.

Perhaps most importantly, given that soft consultation with major stakeholders will already have been undertaken, the SFC will also be looking for feedback from the users of credit ratings, including the issuers of debt securities who engage CRAs to rate their products. The "issuer pays" business model is deeply controversial, with many commentators believing that this arrangement leaves CRAs – whose revenues depend on the issuers whose products they rate – hopelessly conflicted. For this reason, the draft Code of Conduct for CRAs (attached to the SFC's consultation paper) includes a raft of measures designed to ameliorate inherent conflicts of interest in the rating process. These measures will change the way that issuers deal with CRAs, particularly when negotiating fees.

In light of continuing international developments, it is likely there will be some changes to the SFC's proposed regime before it is implemented. Accordingly, the many various parties who may be affected are encouraged to comment. The SFC's consultation paper, which was issued on 19 July 2010, is available at: Source

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