The financial services industry is facing sweeping regulatory reform in much of the developed world in response to the global financial crisis. But that’s not the case in Canada, where the modest impact of the crisis has had relatively little effect on the regulatory landscape.
One exception to that, however, is the credit-rating business, which is now facing a new system of regulatory oversight in Canada.
Given the credit-rating agencies’ central role in the financial crisis and the lack of regulation in this business, it is hardly surprising that it is now facing an oversight overhaul. The core concern for regulators is that investors rely too heavily on credit ratings to assess the riskiness of certain securities, and don’t do enough of their own due diligence. This undue reliance on the credit-rating agencies is exacerbated by requirements in securities legislation that certain products must have credit ratings; yet, the agencies themselves are largely unregulated and there is some concern that their business models are inherently conflicted and that their rating methodologies may be flawed.
These concerns are shared by regulators and policy-makers in many of the countries affected by the financial crisis. In Canada, the crisis was felt most acutely in the failure of the market for non-bank asset-backed commercial paper. A review of that episode by the Canadian Securities Administrators, published in 2008, had highlighted the role played by the credit-rating agencies.
The CSA review found that although the agencies had a hand in the crisis, they didn’t cause it; and greater regulation of their businesses probably wouldn’t have prevented the crisis. Although one can dispute those conclusions, the CSA report nevertheless admits that the weaknesses in agency oversight that were exposed by the crisis should be addressed. At the time the report was released, the CSA had proposed a basic approach to regulating the agencies — which is now being followed up with proposed rules.
Essentially, under the CSA’s proposals, which were out for comment until the end of October, the credit-rating agencies would be required to apply for recognition as an approved rating organization; and, as a condition of that approval, they would have to adopt and adhere to a code of conduct that complies with various elements of a code developed by the International Organization of Securities Commissions. (See sidebar.) Firms would be allowed to deviate from the IOSCO code but would have to explain why that is necessary — an approach known as “comply or explain.”
In addition, the CSA is proposing to impose several other stipulations on the agencies, requiring them to: avoid conflicts of interest; appoint a compliance officer; report certain information to the regulators each year; and to have policies to prevent improper disclosure of potentially market-moving information, such as news of an impending downgrade.
The CSA’s initiative follows similar efforts to ramp up oversight of the credit-rating business in the U.S., Europe and elsewhere. The G20 agenda also has included increasing regulation of the agencies as one of its staple initiatives.
The agencies seem to be accepting their fate. Ordinarily, when regulators seek to expand jurisdiction into previously unregulated realms, they are met with fierce resistance. In this case, based on the comments submitted on the CSA’s proposals, none of the major firms disputes the need for greater oversight. And they largely approve of the CSA’s approach, centred as it is on the IOSCO code.
Although there is some resistance to certain aspects of the CSA proposals, the agencies’ biggest fear appears to be the threat of being exposed to civil liability for their opinions — the prospect that they could be sued for ratings that don’t turn out to be accurate. That has already been a critical issue in the U.S., where regulatory reforms targeting the credit-rating business has meant that ratings included in financial filings, such as prospectuses, could be subject to civil liability, which they haven’t faced in the past.@page_break@To avoid exposure to that liability in the U.S., the agencies say they would not allow their ratings to be used in prospectuses, bringing new-issue activity to a halt. In response, the U.S. Securities and Exchange Commission has temporarily suspended the requirement that certain issuers include credit-rating information in their prospectuses. That moratorium ends in late January; in the meantime, the SEC indicates that it is studying the issue.
The same dilemma is now rearing its head in Canada, as the CSA proposal seeks comment on whether civil liability exemptions for credit-rating agencies should be scrapped here, too. Ideally, regulators could make the agencies more accountable for their opinions by subjecting them to the risk of being sued. But if the result is that new-issue business halts, then one problem has merely been exchanged for another.
Not surprising, all three of the agencies that submitted comments on the CSA’s proposals — DBRS Ltd., Standard & Poor’s Financial Services LLC and Fitch Inc. — indicate that they are opposed to the prospect of facing civil liability for their ratings.
Fitch’s comment indicates that the agency doesn’t want to expose itself to civil liability for its ratings opinions “without a complete understanding of the ramifications” to its business and how it may go about mitigating that liability. Thus, it would not allow its ratings to be used in prospectuses and other financial filings — although it would continue to publish its ratings and research.
The DBRS comment maintains that agencies should remain exempt from civil liability because their ratings offer opinions about future events and are not supposed to be statements of fact, which do face liability in financial filings.
S&P’s comment offers the most spirited defence of the agencies’ exemption from liability, pointing to the forward-looking nature of credit ratings and warning that exposing agencies to liability could hurt the transparency and efficiency of the capital markets in Canada by reducing the amount of publicly available information, making new issues more costly and time-consuming to carry out, and potentially reducing access to capital for new or smaller issuers.
The agencies’ position is echoed in comments from the Canadian Bankers Association and the Business Development Bank of Canada, but opposed in some of the other comments that line up on the investors’ side of things. Indeed, a number of the comments from the investor side support the prospect of the agencies facing liability and would like to see the regulators going further.
For example, the comment from the Canadian Advocacy Council for Canadian CFA Institute Societies says the council supports greater oversight for the agencies as contemplated by the CSA proposals: “…but views this as only an initial step in the process of removing reliance on [agencies’] opinions.” The process, the council’s submission says, should also include removing references to ratings in securities legislation and having the agencies face legal liability for their research opinions.
The comment from the Ontario Secur-ities Commission’s new Investor Advisory Panel (its first on a regulatory proposal on behalf of investors) says that requiring the rating agencies to comply with the IOSCO code is a step in the right direction but doesn’t go far enough to protect investors, as it does not demand full disclosure about who is paying for ratings or how ratings are reached, nor does the CSA proposal promise any punishments for those who fail to comply. Says the OSC statement: “The overwhelming reliance by investors on ratings and the ‘gatekeeper’ function of [agencies] as bodies that facilitate access to capital markets for issuers, turns ratings into a public good that must be closely supervised by regulators.”
The panel’s comment notes that the SEC is setting up a unit specifically to oversee the agencies and calls for Canadian regulators to review ratings directly and to compel greater disclosure: “Investors should be able to know the considerations that were taken into account in arriving at [an agency’s] rating.” It adds that the agencies should be required to provide that information and that it believes that “comply or explain” does not ensure that will happen.
Thus, there is clearly a wide gap between what the agencies would like to see and what investor advocates are calling for. It will be interesting to see how the CSA walks the line between them. IE
Regulating agencies a sure bet
The key question, however, is whether credit-rating agencies will be exposed to civil liability as a result of the CSA’s changes
- By: James Langton
- November 15, 2010 May 31, 2019
- 11:54