The all-powerful credit-rating agencies have received passing grades from European regulators. Now all they have to worry about is fallout from new U.S. legislation.

The Committee of European Securities Regulators, with a few notable reservations, pronounced itself satisfied with the job the major credit-rating agencies are doing in terms of avoiding conflicts and ensuring the independence of their ratings.

CESR’s approval was welcome news for the CRAs, which have faced increased scrutiny from regulators in the U.S. and Europe in the past few years in the wake of corporate scandals in the early part of the decade. When major companies such as Enron Corp. and WorldCom Inc. in the U.S. and Parmalat in Europe blew up, the rating agencies were among the many market players that felt the backlash.

Critics complained that the agencies weren’t quick enough to document the degradation in credit quality of troubled firms. As a result, investors didn’t see the warning signs at the companies until it was too late. The defence offered was that the agencies were as duped by dodgy accounting practices as the rest of the market.

Nevertheless, those episodes put the spotlight on this very powerful and largely unregulated segment of the global financial markets. In the U.S., increased scrutiny of the role of CRAs was one of the lesser-known consequences of the Sarbanes-Oxley Act. Then, in late 2004, the International Organization of Securities Commissions stepped into the fray by publishing a code of conduct for CRAs.

In Canada, regulators’ involvement with the CRAs is primarily through informal dialogue with the agencies themselves, and through participation in IOSCO. Wendy Dey, director of communications and public affairs for the Ontario Securities Com-mission, says the OSC is an active member of the IOSCO Task Force on Credit Rating Agencies.

“We were heavily involved in the task force when the IOSCO code was first created,” she says. “For the past 10 years, we have had active dialogue with the CRAs in Canada in order to understand their activities, which is why we were so involved in the task force.”

European regulators have been checking on the rating agencies. In early January, CESR published a report detailing its examination of the CRAs’ compliance with the IOSCO code.

For the most part, the regulators are pleased with what they found. Their report concludes that the major CRAs generally comply with the code. As a result, the European Commission, which had directed CESR to monitor the agencies’ compliance, concluded that no new legislation is needed for the CRAs.

“The report confirms that self-regulation by CRAs functions reasonably well,” declared EU Internal Market and Services Commissioner Charlie McCreevy. The commission says the right regulatory balance is being struck by relying on self-regulation with reference to the IOSCO code.

The EU notes the report uncov-ered a few areas in which improvement is needed, and it pledges to continue pushing the CRAs to get themselves in full compliance. Ultimately, however, it concludes: “The case for new legislation in this area remains unproven.”

The agencies were pleased with the findings.

“CESR’s report shows that most users of ratings believe the system of market-led accountability, based on the IOSCO code of conduct, is working well,” says Martin Winn, vice president of communications, Europe and Asia-Pacific, at Standard & Poor’s Corp. in London. “The vast majority of respondents to CESR’s survey say they are confident in the quality of ratings and believe the transparency of ratings’ methodologies and rationales has improved.”

In New York, Anthony Mirenda, director of corporate communications at Moody’s Corp. , says, “Moody’s is pleased that CESR’s report found that credit ratings agencies are compliant with the IOSCO code. We are firmly committed to full ongoing participation in the voluntary framework developed by CESR and look forward to working with CESR over the course of 2007.”

At Toronto-based Dominion Bond Rating Service Ltd. , Mary Keogh, managing director of policy and regulatory affairs, says DBRS also welcomes the report and is pleased that European regulators have concluded there’s no need for any new legislation in the credit-rating industry. She stresses that DBRS believes in adhering to the IOSCO code, does so voluntarily and will continue to participate in the process.

Indeed, it appears there is more work to be done. Although the CRAs and the regulators agree that there’s no need for new legislation, they don’t exactly see eye-to-eye on whether the agencies are in full compliance with the IOSCO code.

@page_break@The report identifies several areas in which it has concerns about the CRAs. The big issues are identification of unsolicited ratings and the independence of the CRAs’ “ancillary services,” the products and services they try to sell in addition to providing credit ratings.

The basic concern about unsolicited ratings is that they are derived from different information than paid ratings. They rely largely on public information, whereas paid ratings presumably incorporate inside information.

It’s important for investors to be able to distinguish between the two. Moreover, the industry’s critics have alleged that unsolicited ratings could be used as a tool to drum up business by pushing companies into becoming clients so that their ratings are better informed and possibly even more favourable.

The concern about CRAs selling ancillary services is much the same as the issue of accounting firms providing consulting and other services in addition to their bread-and-butter auditing business. The fear is that the independence of ratings could be compromised if firms are trying to sell additional services to their ratings clients.

The CESR report says that the CRAs acknowledge the concerns, and are trying to avoid the conflicts. The problem, it appears, is largely one of interpretation. For example, the CESR suggests that, although the rating agencies are willing to separate out their ancillary services, they don’t necessarily agree on what constitutes an ancillary service and what is part of the ratings process.

Specifically, they all see “ratings assessment services” — which includes providing insight into the possible ratings impact of a strategic move, such as a merger — as part and parcel of the ratings business. CESR concedes that such services may be considered integral to the ratings business. But, it insists, it still poses potential conflicts of interest, and it’s not clear how firms are managing the conflicts. CESR also says there are differing degrees of separation of ancillary services among various CRAs.

Similarly, in terms of unsolicited ratings, the CESR says it’s essential that rating agencies disclose whether a rating is solicited or not. It notes that the CRAs generally agree with the stance but, again, they have different interpretations of what constitutes an unsolicited rating. The term is not defined in the IOSCO code.

Such differences in interpretation and definitions appear to be at the root of any question of whether the CRAs are in full compliance with IOSCO. The code was intended to be flexible enough to accommodate different sorts of agencies, rather than trying to force them into a rigid regulatory regime.

S&P and Moody’s both maintain they are properly managing conflicts related to ancillary services. Winn says S&P “applies robust operational separation” between businesses. Moody’s insists the ratings assessment business is properly considered part of the ratings business.

Similarly, Winn says his firm only provides unsolicited ratings “on a very limited basis in response to market demand. We ensure full transparency by always indicating clearly when a rating is unsolicited.”

Moody’s has not assigned any unsolicited ratings recently, Mirenda says, and its policy describes how it would disclose them in the future. To promote transparency, he adds, it discloses non-participation by an issuer in all credit-rating announcements relating to that issuer. It also discloses a list of non-participating issuers on its Web site.

“While we believe these two disclosure mechanisms are comprehensive, we will evaluate other options for identifying non-participating issuers on a continuous basis,” Mirenda says.

DBRS’ Keogh did not comment on the specific areas in which the CESR says it deviates from the IOSCO code. She notes DBRS had an opportunity to comment on the report before it was finalized, and to explain why it believes it is in compliance with the IOSCO code.

She says regulators should give some thought to providing more concrete definitions, particularly in terms of what constitutes an unsolicited rating and what should be considered an ancillary service, “because those are grey areas.

“I realize the world’s not black and white. But it’s hard to tell if you’re in compliance if there’s no clear definition,” Keogh notes.

Although the CESR doesn’t see a need for more CRA regulation, there is a different view in the U.S., where a bill was passed last fall that gives the Securities and Exchange Commission more power over the ratings business, while also opening it to greater competition.

The move was acclaimed by the U.S. financial services industry.

Jim Kaitz, president of the Association for Financial Pro-fessionals, issued a statement saying the new law “will open the credit-rating market to competition and transparency, and restore confidence in it. Importantly, the new law gives the SEC the tools to hold recognized rating agencies accountable if they fail to produce credible and reliable ratings.”

The bill was also welcomed by trade groups Investment Company Institute and Financial Executives International.

Although the EU has opted not to tinker with regulation, it will continue to monitor developments in the CRA market, and will pay particular attention to the impact of the new U.S. regime, which will be in operation by next summer.

It remains to be seen how the new environment changes the ratings business. What is clear is that investors are the beneficiaries of all efforts to ensure the independence and integrity of credit ratings. IE