1. Rating agency
Rating agencies assess the credit worthiness of issuers or financial instruments. Ratings heavily influence investors in their decisions to buy or sell. The rating states the probability at a certain moment in time that an issuer will be able to fulfil either all his financial obligations or his obligations under a single debt instrument or fixed-interest security (issuer rating and issue rating). Besides private companies, public bodies and states can also be subject to ratings. Ratings are expressed through a specific and detailed solvency scale ranging from the highest (investment grade) to the lowest (speculative grade) classification. The grade of risk is often expressed by a combination of letters ranging from AAA for the highest solvency to D for payment default or insolvency. Ratings, like financial analyses, are mostly regarded as an expression of opinion. However, in most countries the rating is not seen as a recommendation, and, therefore, the rules for financial analysts are not applicable. Ratings solicited by a client have to be distinguished from unsolicited ratings. For these, the agency does not have access to the internal data of the issuer. Besides their core business, rating agencies often provide risk assessments in the context of consulting on investments or the structuring of financial products.
2. Concept and purpose of a rating
The information services of rating agencies enable financial intermediaries in the narrow sense. Financial intermediaries, especially banks (European banking market), serve to match the supply of and the demand for financial funds in a wide range of economic relations, in particular between private households and commercial entities. In essence, they compensate for differences in batch sizes, maturity, liquidity and risks by transforming assets or liabilities into different forms of assets and liabilities (transformation function). Information services of an impact similar to ratings are provided by financial analysts and auditors. Together with the aforementioned, rating agencies are considered the most important information intermediaries in financial markets (or financial intermediaries in the broader sense). The overall role of financial information intermediaries is to verify available information, evaluate it in line with macroeconomic developments and supply missing information. The services of the mentioned information intermediaries complement one another and partly build on each other directly or indirectly. Nonetheless, they all have their specific goals and follow specific methods. The focus of a rating lies in an evaluation which refers to the present situation of an issuer. Similarly, the verification provided by an auditor refers to the present situation. These services can hence be differentiated from financial analyses whose evaluations refer to the future.
The rating is based on an analysis of quantitative data such as revenue, cash flow and equity ratio. It also includes sector risks and risks of the national or global economy. Also, qualitative criteria like past debt payment attitudes and the corporate governance of the issuer are assessed. Specifically in order to assess the qualitative criteria, rating agencies usually contact the management of the issuer.
Nowadays, ratings are a part of contract drafting as well as financial markets all over the world. So-called rating triggers connect default risk assessments with certain legal consequences. This applies, for instance, to long-term loans, where the interest rate is linked to a solvency assessment of the debtor. Technically, these are usually conditions precedent or subsequent. Ratings are of special importance for financial intermediaries in the narrow sense, as ratings of debtors influence the capital requirements of banks. The solvency assessment and risk classification of banks themselves may be relevant for measuring the contribution to a deposit guarantee fund. However, at least in Germany risk assessments for this purpose are not conducted by rating agencies but by specialized auditing associations. Some states tie further supervisory rules to a certain rating result. For example, the possibility for a pension fund to invest in private bonds may depend on their rating. Additionally, the listing rules of exchanges, as those of Euronext, tie the placement of financial instruments to the submission and publication of a rating.
In the context of financial markets, the rating regularly constitutes the legal condition for external financing with the help of financial instruments such as bearer bonds. This is especially true for new issuers or those that are not yet fully established. Broadly speaking, interest rates and stock quotes depend to a considerable extent on the assessment of rating agencies. To a considerable degree the rating thus determines the costs of capital acquisition.
3. State of European legal harmonization
European legal harmonization with regard to rating agencies proves to be in an early stage in comparison with other financial intermediaries. It is only in 2009 that general obligations were enhanced by a regulation specifically addressing rating agencies.
To start with, general rules on market conduct initially stem from Dir 2003/6 on market abuse sanctioning any kind of influence on the prices of financial instruments, ie insider dealing and market manipulation. The rules on conflicts of interest are of special importance for rating agencies, such as the ones concerning appropriate presentation of investment recommendations and the access to insider information. Like financial analysts, rating agencies also have to adhere to internal principles and processes in order to secure a proper procurement of information. Additionally, all noteworthy interests or conflicts of interest regarding an issuer or financial instrument being subject to a rating have to be disclosed. If a rating agency comes across insider information, strict confidentiality has to be maintained until publication by the issuer. Even the rating itself may constitute insider knowledge and therefore may not be used for investment purposes.
Furthermore, the Markets in Financial Instruments Directive (MiFID, Dir 2004/39), whose concept resembles a constitution for financial markets, should be mentioned. The scope of the MiFID and its implementing provisions only include rating agencies if they provide services for financial instruments in the manner of other financial intermediaries. Therefore, rating agencies may be subject to the approval of a supervisory body as well as the intricate code of conduct and the organizational rules of the MiFID. For example, regarding investment consulting services, this may necessitate (expensive) organizational measures in order to separate investment services from ratings.
Although they are only applicable indirectly, the importance of the directives on capital adequacy of investment firms and credit institutions (Dirs 2006/48 and 2006/49) can hardly be underestimated. In connection with these instruments, rating agencies have to adhere to the Basel Committee on Banking Supervision’s 2004 Framework ‘International Convergence of Capital Measurement and Capital Standards’ (Basel II, revised 2005). According to the framework, risk measurements and the resulting equity requirements for credit institutions and investment firms may be determined on the grounds of external ratings. The competent supervising bodies, however, only accept ratings of accredited agencies. The accreditation process is regulated by the directive itself, clarifying the necessary objectivity, independence and transparency of the rating. Additionally, the agencies have to check the published solvency reports regularly.
Apart from that, regulation of rating agencies has thus far been based on self-regulation through codes of conduct (private rule-making and codes of conduct) more than in the case of auditors or financial analysts. As with financial intermediaries in general, the recommendations and reports of the International Organization of Securities Commissions (IOSCO) are of high importance for rating agencies as well. In 2003 the IOSCO published its ‘Code of Conduct Fundamentals for Credit Rating Agencies’, last revised in May 2008. These standards go far beyond the EU legislation described above. They include concrete behavioural patterns regarding supervision and verification of rating quality. Most importantly, detailed recommendations to ensure independence of the agency and its employees as well as avoid conflicts of interest have a noteworthy role.
On 16 September 2009 Reg 1060/2009 on credit rating agencies was adopted and large parts of the IOSCO recommendation were made directly applicable within the Member States. This has resulted in an overdue approximation of the rules for rating agencies with the rules for other financial intermediaries in the broader sense such as auditors and financial analysts, and it closes an evident legal gap.
4. Regulatory structure and issues
The debate on the regulation of rating agencies raises similar fundamental questions concerning the scope and limits of market forces as compared to financial analysts. Also in the case of rating agencies, the debate was not only triggered when the recent financial crisis of 2008 started but already in 2001 by the unexpected downfall of Enron, the second largest US energy supplier. Enron had received investment grade ratings by leading agencies only a few weeks before filing for bankruptcy. After the comparably unexpected downfall in 2003 of Parmalat, an Italian supplier of dairy products, it was clear that the US regulatory system for rating agencies was not the only entity to blame for the development.
The then in force IOSCO Code was built on voluntary adherence. It was not completely enacted by legislation in any of the European Member States. However, some rating agencies followed the code, and some also drafted their own codes of conduct on that basis. The three largest agencies additionally committed themselves at the turn of the year 2005/06 to provide a yearly letter on their measures to implement the IOSCO standards to the Committee of European Securities Regulators (CESR) constituted by the European Commission. According to the CESR’s report of 2008, the grade of implementation of the IOSCO recommendations had been high.
Initially, the European Commission agreed with the first CESR annual report of 2005 which stated that a proper balance between state and self-regulation had already been found (Communication 2006/C 59/02). Scepticism about this assessment was triggered with the financial crisis that broke out with the collapse of the investment bank Lehman Brothers in 2008. One of the presently known causes of the crisis was severe overvaluation or lack of accurate risk assessment on the US mortgage market. These misperceptions were bundled into structured financial products, and the high degree of complexity of those products made it difficult to estimate risks even for professional market participants like banks. It is important to note that early warnings by rating agencies were missing in this instance just as they had been in the earlier cases of Enron and Parmalat, mentioned above.
In 2008, the report of the European Securities Markets Expert Group (ESME) presented further measures to improve corporate governance of rating firms and, especially, to prevent conflicts of interest. They were first implemented in 2008 but only by the means of amending the IOSCO recommendations, which still were on a voluntary basis.
The regulation adopted in 2009 advocates comparable competition standards between the Member States and hence accommodates the natural cross-border dimension of financial information. A general obligation to register or certify foreign agencies is a symbol of innovation. A coherent application of the regulation is thought to be ensured by the CESR receiving requests and forwarding them together with a recommendation to the body in charge in the country of origin. As a direct reaction to the financial crisis, the ratings of structured financial products now require a specific labelling.
Additional measures on the improvement of internal supervision are well known in the general corporate governance debate. At least a third of the members of the administrative or supervisory body should be independent. This means that they may not be in an executive position at the same time, and that they meet the additional requirements set out by the European Commission for listed companies (Recommendation 2005/162). Accordingly, the regulation stipulates a disassociation of remuneration and economic success. Relevant expertise is necessary, demanding in certain cases specific knowledge on structured financial products. A comprehensive compliance system is also required. Surprisingly, the regulation does not call for a separation of the roles of the chairman of the board and the chief executive officer (CEO) as advocated in the 2008 ESME report.
At the core of the regulation one can find the rules to prevent conflicts of interest following the approach known from the legislation applicable to auditors. The danger of financial dependencies is met by transparency requirements. The rating report has to state the names of clients responsible for more than 5 percent of the agency’s income. In the US, ratings may not be provided for a single issuer if the agency derives 10 percent of its yearly income from that issuer. This is more consistent with the approach toward auditors, who are banned from audits with great financial dependencies. The less strict European transparency obligations, now applicable to rating agencies, are meant to strike a balance between the dangers from financial dependencies with the objective of opening the market for small firms that are trying to establish a base of more than 10 or 20 clients.
The prohibition of self-assessment is a rule inherent to the law of information intermediation. Accordingly, the regulation bans the rating of an object encompassing an agency investment, the personal interdependence of non-executive directors or a conflict of interest of the individual analyst. As with auditors, independence is strengthened by rotation rules. Managing analysts rotate after four years and others after five years of rating the same company.
In line with international standards, ratings cannot be combined with consulting services regarding legal structure, assets, liabilities or operations of the rated company. Mere ancillary services like the analysis of general economic data in market forecasts are admissible but have to be disclosed in the report. The adherence to the rules can be effectively supervised on the grounds of documentation requirements.
Complementary transparency requirements support the disciplining powers of the market. The accuracy of the rating has to be reported biannually. Yearly reports are necessary with respect to big clients, income from ratings and ancillary services, the equity structure as well as internal compliance provisions.
5. Prospects of harmonization
The perspectives of harmonization in the area of rating agencies have been triggered by a proposal for amending the Regulation (EC) No 1060/2009 on credit rating agencies published by the European Commission on 2 June 2010 (COM  289 final). The proposal focuses on strengthening the supervision of rating agencies and seeks to back up effective enforcement by a catalogue of sanctions. On 5 November 2010 the European Commission launched a ‘Consultation on Credit Rating Agencies’ which asks a whole series of questions on the role of rating agencies and the impact they can have on markets. The consultation asks whether it is right that European and national legislation rely on external credit ratings and how possible overreliance could be addressed. A more specific set of questions concerns improvements on sovereign debt ratings, including transparency, monitoring, methodology and the rating process.
It also deals with the pressing challenge of how to open the market for new competitors. The worldwide oligopoly mainly consists of the two large rating agencies, Moody’s and Standard & Poor’s, as well as the smaller Fitch, all of them with a US background. Therefore, the market is even more concentrated than the one of auditors—leading to all the described dangers of oligopolistic market structures (auditors). The cause for the market concentration in case of rating agencies is often traced back to the accreditation requirements implemented in the United States in 1975. Agencies can only be registered with the evidence of a certain acceptance of the ratings in the market. The Credit Rating Reform Agency Act of 2006 tackled the problem of entry barriers, introducing a formal accreditation procedure. However, the procedure is still based on market presence and acceptance. Because of the dominance of the US rating agencies, an intensive transatlantic dialogue in particular with the US Securities and Exchange Commission (SEC) is necessary. The planned European system of financial supervisors will enhance the ability to speak with one voice.
Furthermore, the consultation paper addresses central problems of information intermediation in general. A lack of competition can negatively impact the quality of services provided by information intermediaries. This is true for credit ratings but also for external audits (auditor). A possible way to improve quality could be to introduce a common civil liability regime. Moreover similar problems arise from the issuer-pays model and it is not surprising that proposals to install a public information intermediary can be found in the area of rating as well as auditing. This raises the basic question of whether and how private rating agencies and other information intermediaries should be included in a coherent gatekeeping concept which allows them to de facto substitute functions of public supervisory authorities (financial intermediaries).
Mathias Habersack, ‘Rechtsfragen des Emittenten-Ratings’ (2005) 169 ZHR 185; Gérard Hertig, ‘Using Basel II to Facilitate Access to Finance’ in Klaus J Hopt, Eddy Wymeersch, Hideki Kanda and Harald Baum (eds), Corporate Governance in Context (2005) 511; Arthur R Pinto, ‘Control and Responsibility of Rating Agencies in the United States’ (2006) 54 American Law Journal (Supplement) 341; John C Coffee, Gatekeepers (2006); Fabian Dittrich, The Credit Rating Industry—Competition and Regulation (2007); The Committee of European Securities Regulators, 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, ref CESR/08-277 May 2008; Jacques de Larosière (chairman), Report of the High-Level Group on Financial Supervision in the EU (2009); Thomas MJ Möllers, ‘Credit Rating Agencies under New US and EU Law—Import Steps or Much Ado about Nothing?’ (2009) 4 Capital Markets Law Journal 477; European Securities Markets Expert Group, ESME’s Report to the European Commission—Role of Credit Rating Agencies (2008); Patrick C Leyens, ‘Intermediary Independence: Auditors, Financial Analysts and Rating-Agencies’ (2011) 11 Journal of Corporate Law Studies 33, earlier version in German: ‘Unabhängigkeit der Informationsintermediäre zwischen Vertrag und Markt’ in Harald Baum and others (eds), Perspektiven des Wirtschaftsrechts—Beiträge für Klaus J Hopt (2008) 423.