Rules proposed to regulate Canada’s credit-ratings agencies for the first time may go some way in restoring confidence in an industry battered by the asset-backed commercial paper crisis. But, industry observers say, repairing the damage will take time.

They also say the proposed rules wouldn’t excuse financial advisors from doing their own due diligence when assessing the risk of debt securities for their clients.

“The [agencies] need to demonstrate [they have more] competency in rating complex products for that confidence to come back,” says Ian Russell, president and CEO of the Toronto-based Investment Industry Association of Canada.

The agencies have been heavily criticized for their role in the ABCP crisis. Ratings from agencies on these complex financial products gave many advisors and investors the notion that the investments were far less risky than they were.

When the U.S. housing market crashed in 2007, the ABCP market dried up and many investors found their investments illiquid. In Canada, non-bank ABCP collapsed the same year; many investors found they could not access their funds.

One of the issues highlighted by the crisis is the inherent conflict of interest in the agencies’ business model — the credit-rating firms are compensated by the companies whose securities they structure and rate. The new rules attempt to deal with this matter.

Under the Canadian Securities Administrators’ proposed Nation-al Instrument 25-101: Designated Rating Organizations, the credit-rating agencies would need to outline the processes behind running their businesses — specifically, how they assign ratings to the corporate debt and structured products they are evaluating.

An agency would have to apply to its securities regulator for “designated rating organization” status. It would also need create an enforceable code of conduct relating to how it issues ratings, in compliance with International Organization of Securities Com-missions standards.

In the code of conduct, credit-rating agencies would have to outline their procedures for dealing with conflicts of interest.

The proposed rules outline what constitutes a conflict of interest and prohibit an agency from issuing a rating on a security if:

> a credit analyst assigning the rating owns a part of the company he or she is evaluating;

> the agency is affiliated or associated with the company it is evaluating; or

> the fees paid to the agency for the rating were negotiated or discussed directly with the analyst involved in determining the rating.
@page_break@Furthermore, an agency would be required to appoint a compliance officer to oversee its processes.

The deadline for industry comment on NI-25101 is Oct. 25.

Agencies caught in the downdraft of the ABCP crisis include Toronto-based Moody’s Canada Inc., a subsidiary of Moody’s Investors Service Inc.; Toronto-based DBRS Ltd. ; and New York-based Standard & Poor’s Financial Services LLC.

Prior to the CRA proposal, DBRS had already prohibited its analysts who participate on a rating committee from negotiating fees with DBRS clients, says Huston Loke, co-president of DBRS, adding that the proposed rules will only help further codify best practices in the credit-rating industry and within the company.

“Ourselves, as well as the regulators, have recognized that it’s important to be vigilant and ensure that we are following best practices,” says Loke. “Any changes that we make will be to increase the independence that analysts have from the business and fee side.”

Overall, DBRS agrees that Cana-dian regulators getting more involved in the credit-rating industry is a good thing. “We are pleased the CSA has looked at IOSCO,” says Loke, “and that there is an ability to enforce those standards with periodic inspections.”

But a tighter regulatory belt doesn’t mean financial services firms and investors should relax their own due diligence in evaluating debt products, Russell notes: “We as an industry have an obligation on risk assessment.”

This means financial advisors, along with portfolio managers, have a responsibility to consult their in-house research departments for their own internal analysis on a security’s risk level before recommending it to clients.

Sophisticated investors, such as pension fund managers and brokers, have been doing that since the ABCP debacle, for the most part, says Russell. They have created more of their own sophisticated methods for analyzing the risk of debt securities.

“They have beefed up their infrastructure,” says Russell, “to manage the risk of their securities and complement the agencies’ ratings.”

Dan Hallett, director of asset management with Oakville, Ont.-based HighView Asset Management Inc. , notes that portfolio managers will use the ratings only as a screen for products: “They won’t buy something because its rating is BBB. The rating is only a starting point for more research.”

However, the CRA’s proposed rules may not have a significant impact on the way credit-rating agencies evaluate debt or on the ratings they assign, says Alan White, professor of finance at the University of Toronto’s Rotman School of Management and a member of Moody’s Canada’s advisory council: “Regulators are issuing these changes because they want the [agencies] to behave reasonably. But these are Fortune 500 companies, not fly-by-night operations. And, for the most part, they already have most of the processes the rules outline in place.”

If anything, the new rules will add to the agencies’ administrative burden, says Hallett: “There’s certainly an increased burden on the companies for more documentation, with the new DRO licensing they will have to apply for.”

The new rules — if approved — could mean that credit-rating agencies face annual inspections by Canadian regulators, says Loke. DBRS is already inspected annually by the U.S. Securities Exchange Commission because it is active in the U.S. securities market.

IE