This short article will highlight significant and major improvements to Regulation 1060/2009 on credit rating agencies, as amended from time to time (the “CRA Regulation”) and approved by the European Parliament last January. Those significant and major improvements are the introduction of a mandatory rotation rule, the setting up of a calendar for the rating of sovereign debts and the introduction of a civil claim system against credit rating agencies (the “CRAs”).
Remember that CRAs do not only pass judgement on the creditworthiness of companies, such as financial institutions and their financial products, but also on states themselves. The current euro area crisis highlights the huge consequences that can arise from downgrading a sovereign state, not only for the financial markets but also for the state itself.
A long relationship between a CRA and an issuer could undermine the CRA's independence, and, in view of the "issuer pays" model, it could also lead to a conflict of interest that could affect the quality of ratings.
To this end, the new rules introduce a mandatory rotation rule forcing issuers of structured finance products with underlying re-securitised assets, which pay CRAs for their ratings ("issuer pays model"), to switch to a different agency every four years. An outgoing CRA would not be allowed to rate re-securitised products of the same issuer for a period equivalent to the duration of the expired contract, although not exceeding four years. However, mandatory rotation will not apply to small CRAs, or to issuers using at least four CRAs when each of those CRAs rates at least more than 10% of the total number of outstanding rated structured finance instruments.
While the European Commission had proposed a broader scope for the new rule, the compromise limits the rotation rule to re-securitisations. This can be seen as an important way to test the effectiveness of the rotation rule, even if the lack of a broader scope could still fall short of eradication of conflict of interests.
To avoid market disruption, CRAs will be required to set up a calendar for sovereign debt rating which will be limited to three ratings per year for unsolicited sovereign ratings. Change in the schedule of sovereign rating or related rating outlooks shall occur under strict conditions. These ratings will only be published after the close of business and at least one hour before the opening of trading venues in the EU.
Moreover, sovereign ratings would have to be reviewed at least every six months (rather than every 12 months, as currently applicable under general rules).
Ratings have important consequences. Therefore, CRAs should operate responsibly and be more accountable for their actions, as ratings are not innocuous. The new system does not address "wrong ratings". Investors will only be able to sue a credit rating agency which, intentionally or with gross negligence, infringes the obligations set out in the CRA Regulation, thereby causing damage to investors. This new system will ensure that rating agencies will act more responsibly, as they can be held liable by investors and issuers.
The new rules do not include a reversal of burden of proof for civil claims. However, the regulation ensures that the competent court will need to take into consideration that the investor or issuer may not have access to information, which is purely in the hands of the credit rating agencies.
It could be questioned whether the possibility of suing credit rating agencies would not be more effective with the introduction of a reversal of burden of proof.
Those new rules are definitive additional steps towards better regulation of the financial services industry and demonstrate the willingness of the regulators to enhance the protection of investors.