CN_CMI May 25 Slides (1)

8/8/2019 CN_CMI May 25 Slides (1)

1/25

Credit Rating

Agencies

Public and Private Uses ofCredit Ratings

Christopher C. Nicholls

May 25, 2005


2/25

Four topics of investigation Public (legislative and regulatory) uses ofcredit

ratings

Private (uncontracted-for) uses ofcredit ratings

Potentialliability for credit rating agencies

arising fromprivate use ofratings

Alternatives to the use ofcredit ratings


3/25

Public (or Regulatory) Uses of

Credit Ratings Such use documented in U.S.

See, Financial Oversight ofEnron: The SEC and Private-Sector Watchdogs, Reportof the Staff of the Senate Committee on Governmental Affairs (October 8, 2002) at101 ff.

SEC, Report on the Role and Function ofCredit Rating Agencies in the Operation ofSecurities Markets (January 2003) at 28.

And Internationally See, e.g., Basel Committee on Banking Supervision, Credit Ratings and

Complementary Sources ofCredit Quality Information (July 2000) at 41 ff.

IOSCO Report on the Activities ofCredit 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.


4/25

Initiatives Europe:

European Parliament Resolution (Feb. 2004)

CESR Report to EC (March 2005)

IOSCO

Statement ofPrinciples Regarding Credit Rating Agencies Code ofConduct Fundamentals for Credit Rating Agencies

(2004) (comply or explain approach)


5/25

Critical role ofcredit-rating agencies has

recently led to:

Proposed Exchange Act Rule 3b-10 (re: NRSROs)

Proposes defining NRSRO in terms of3 components:

Free Public Availability/Current Assessments of

Creditworthiness

Market Acceptance

Systematic Procedures (reliability, manage conflicts, prevent

misuse ofconfidential information) and Adequate Resources


6/25

Suggestions in the U.S. that legislative

authority tooversee 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)


7/25

Public Use ofCredit Ratings U.S.

In U.S., credit ratings referenced in at least 8 federal statutes, 47 federalregulations, 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


8/25

Provincial Legislation (other than

Securities laws)

At least 37 provincial statutes (or

regulations) in addition to securities laws

in which the concept ofcredit ratings or

approved/recognized credit/bond rating

agency is used


9/25

Selected Examples ofRegulatory

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


10/25

Provincial Legislation (Securities

Laws)

At least 10 National Instruments or

National Policies use concept ofapproved

credit ratings

Also included in a numberofprovincial

securities rules and regulatory instruments


11/25

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 civilliability (Rule 41-501, s.13.4(4); s. 130(1)(d))

Eligibility foruse ofShort Form Prospectus for certain debt and prefshare issues (NI 44-101)

Eligibility to distribute securities underMJDS (NI 71-101, s. 3.1(a))

Requirements formoney market funds (NI 81-102, s. 1.1 (definitionofmoney market funds and s. 15.3(5),(6))

ProposedNI 45-106, registration and prospectus exemption forcommercialpaper (NI 45-106, s. 2.36(1), (2))


12/25

[credit] ratings formpart of the

statutory framework ofprovincialsecurities legislation

National Policy 51-201, s. 3.3(7)


13/25

Private Uses ofCredit Ratings Ratings Triggers

Issues: Propriety ofusing ratings triggers Effect ofrating 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)


14/25

Ratings Triggers Issue Studied by CRAs, see, e.g.:

The Unintended Consequences ofRatings Triggers(2001)

(Pamela Stumpp (Moodys) )

"Moody's Analysis ofUS 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)


15/25

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 ofborrowing base, and springing liens

Qualification ofpermitted assignees


16/25

Liquidity Implications Reporting issuers must disclose in liquidity

portion ofM D & A, ratings triggers that

could trigger an additionalfundingrequirement or early payment or that

could impair your companys ability to

undertake transactions Form 51-102 F1, Part 2, item 1.6, instruction (ii)


17/25

Other Triggers Other triggerssuch as those affecting

pricingmight not be required tobe

disclosed in M D & A and yet may, inaggregate, be material to an issuer

Not just downgrades that may adverselyafffect issuers


18/25

Potential Civil Liability for CRAs Twoprincipalpotential sources ofliability:

Action brought by rated issuer

Action brought by third party users ofratings


19/25

Potential Civil Liability Threat ofaction by rated issuers could

(theoretically) pressure CRAs tobe more

sanguine in their ratings decisions

Threat ofaction by third-party users could

(theoretically) pressure CRAs tobe moreconservative in their ratings decisions


20/25

Liability to Third Parties Risk ofLiability for CRAs to third party

users ofratings is low

Under securities laws, CRAs largely

insulated from statutory civilliability (e.g.,

Ontario Securities Act s. 130)


21/25

Liability ofCRAs Common law:

Debatable whetherprima facie duty ofcare underfirst

stage ofAnns/Kamloops

Even ifprima facie liability underfirst stage, risk ofindeterminate liability negatives duty under secondstage (Hercules Mangements)

Even ifpossible liability underAnns/Kamloops, CRAstypically responsibility (Hedley Byrne)


22/25

Alternatives to Credit Ratings From SEC Concept Release 33-8326:

Allow the use ofinternally-developed credit ratings (by broker-dealers) (Conflicts?)

Industry SROs 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 ofABSdeals) specified asset and structure experience criteria

Coverage Ratios?

Credit Spreads?


23/25

Alternatives to Credit Ratings Private contracts: Ifmarket regarded alternatives

as superior to credit ratings, alternatives wouldbe used

Regulatory uses: Alternatives such as creditspreads may not be an adequate substitute forcredit ratings because:

Too volatiletoomany false negatives? [Stability isvalued for credit ratings]

Information asymmetry


24/25

Conclusion Public and private uses ofcredit ratings are useful, no superior alternative to credit

ratings for these purposes exists, and such use should not be discouraged

Legislative and regulatory use ofcredit ratings originally simply a reflection ofmarketreality, but now impacts the market

CRAs fundamentally different from registrants

Regulation through controlofdesignationwith only sanction a removalofdesignationplaces regulator in relationship with CRA similar to CRAs relationshipto rated issuer

However, no single regulatory orlegislative recognition of approved credit rating

agencies for Canadian purposes

Further, given the recognition ofCRAs as NRSROs in the U.S., and ECAIs for BISpurposes, unlikely that Canadian regulators can (or should) act unilaterally.


25/25

CN_CMI May 25 Slides (1)

Documents

Transcript of CN_CMI May 25 Slides (1)