The Legal 500

Comments on legal basis and main features. The recent financial crisis has shown many of the weaknesses in the current regulatory framework of the financial market - a lack of or insufficiencies in the legal rules on the one hand and a lack of or insufficiencies in the competency and expertise of financial market supervisors and regulators on the other.

Introduction

The recent financial crisis has shown many of the weaknesses in the current regulatory framework of the financial market - a lack of or insufficiencies in the legal rules on the one hand and a lack of or insufficiencies in the competency and expertise of financial market supervisors and regulators on the other. Apart from these failures on the regulatory side, the crisis pointed out many shortcomings in the behaviour of financial institutions and investors - the lack of skill and knowledge to identify and assess relevant risks and often reckless behaviour. One of major root-causes of the financial crisis can be seen in the development of securitised financial instruments. The mere fact that most investors, as well as regulators, tend to rely on credit ratings explains why the role of the credit rating agencies assessing the credit worthiness of financial instruments and their issuers are so important.

Activities of credit rating agencies have not been subject to any systemic regulation until very recently. Only at the beginning of the new millennium were major regulatory initiatives launched in some jurisdictions - which were then followed by initiatives at the global level. These regulatory initiatives unfortunately were not capturing most of the risk that the activities of credit rating agencies posed to the market.

The recent regulatory actions being taken both in the European Union and in other G20 states do have much in common. The main aim is to enhance the transparency of the activities of the credit rating agencies and to ensure pre-requisites for the quality and integrity of the issuance of credit ratings. The new legal framework for credit rating agencies which have been recently approved in the European Union tackles these issues and does have the ambition to be a template for others to follow. The purpose of this article is to point out some specific features of the new Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 on credit rating agencies ("CRA Regulation"), which may indicate the trends in the way the European legal framework for financial markets may be shaped in the future.

 

Legal Basis

European Legislation - directives and regulations can be based on various provisions of the Treaty on the establishment of the European Community ("EC Treaty"). The choice of the legal basis made by relevant European institutions cannot be determined arbitrarily by that institution, but must be based on "objective elements susceptible to the judicial control", as have been articulated by the European Court of Justice ("ECJ") in its case law. These elements represent generally the purpose and the substantive content of the relevant legislative act. When an institution pursues several purposes to be covered by a single legislative proposal, then the selection of the legal basis should be determined in accordance with the crucial focus of the relevant legislative act. The efforts of the Community to create a harmonised legal framework are, by their nature, a contradiction of Member States´ sovereignty and the will to keep as much national discretion as possible. The fact that the Member States have given up certain parts of their sovereignty and "rendered" certain powers to the Community institutions is articulated in the EC Treaty, limiting the actions of the European Community by the established principles of subsidiarity (article 5 (2)) and proportionality (article 5 (3)). These principles require the European Community to take actions which do not exceed what is necessary to achieve the objectives of the EC Treaty. These actions should be as simple as possible and should leave a leeway for the Member States to choose forms and methods as possible. Also there is a general requirement that directives be preferred to regulations and framework principal based directives to detailed measures. As the concept of the subsidiarity should be understood as a dynamic one and, while it should be applied in the light of the objectives as set out in the EC Treaty, it allows the Community to take actions within the limits of its powers to be expanded where circumstances so require, and conversely, to be restricted or discontinued in cases where it is no longer justified. The Commission, having the right of legislative initiative, should always closely follow these general rules on the application of the principles of subsidiarity and proportionality, and justify the relevance of its proposals with regard to the principle of subsidiarity. It should also take duly into account the need for any financial or administrative burdens imposed on member states or industry.

The current European legal framework for financial services has been significantly re-modelled as result of the Financial Services Action Plan, utilising the Lamfalussy procedure. As yet most of the European financial services law is represented by directives creating the basic legislative framework supplemented by implementing measures consisting of directives and regulations. These framework directives are mostly based on provisions of the EC Treaty dealing with the right of establishment - articles 44 or 47 (2). These articles form the legal basis of both directives, regulating financial institutions and the provision of financial services and the directives regulating the issuance and the offer of securities. When the purpose of the directives is two-fold, this reference to articles on the right of establishment is accompanied by references to other relevant articles - which is the case of the Transparency and Prospectus directives - which are based not only on article 44, but also on article 95 (establishment and functioning of the internal market). Unlike the framework directive for banks - the Consolidated Banking Directive - and MiFID, both having the legal base of article 47 (2), the new Solvency II framework directive has a much broader legal basis - article 47(2), 55 (free movement of services) - as well as article 95. This brief overview clearly shows that the crucial legal basis for the European financial services law is the right of establishment, to which references all major directives in this field.

A somewhat innovative way of determination of the legal basis has been undertaken in the case of the CRA Regulation, which does not refer however to the right of establishment as having a legal basis solely on article 95 of EC Treaty. Article 95 deals primarily with the approximation of provisions laid down by law, regulation or administrative rules in the Member States which have as their objective the establishment and functioning of the internal market. There is no further specification of such provisions as to what may be interpreted as provisions of a sort which may have relevance to the internal markets that may be harmonised arbitrarily by the Community institutions. Though there are some limits to this articulated in the case law of the European Court of Justice, the Community institutions are not conferred general powers to regulate internal markets. On the other hand there are specific areas referred to in article 95 (3) where the approximation is explicitly envisaged by the EC Treaty - health safety, environmental protection and consumer protection. The focus of the approximation of laws in these areas is clearer as article 95 should be read in conjunction with article 153, which requires the Community to "promote the interests of consumers and to ensure a high level of consumer protection, the Community shall contribute to protecting the health, safety and economic interests of consumers". Paragraph 3 of article 153 specifies that the measures adopted pursuant to article 95 should be taken in the context of the completion of the internal market. Most of the European legislative measures based on article 95 have dealt particularly with these areas of health safety and consumer protection and with measures protecting and enhancing the functioning of the internal market. Though the financial services directives often do refer to certain aspects of investor protection, they have rarely referred to the legal basis of article 95 being based crucially on articles dealing with the right of establishment. The Community regulatory framework for the whole industry sector has not been based solely on the provision of article 95 of the EC Treaty as yet.

Apart of the material scope of the article 95, there is another important procedural aspect. The procedure referred to in article 95 enables the issuance of not only directives, but also regulations unlike articles of the EC Treaty dealing with the right of establishment and the free movement of capital. While directives are subject to possibly diverging transposition by the Member States, regulations can take direct effect throughout the Community, thus potentially providing for more consistent and harmonised legal framework. The measures referred to in article 95 are proposed by the Commission and issued in the procedure of a co-decision by the Council and Parliament. Both the Council and the European parliament always try to shape the act according to the interests of their respective members. It is definite that the position of the European parliament is more in favour of higher standards of consumer protection, as has been clearly demonstrated during the negotiation of the Regulation.

In respect to the subsidiarity, the Commission, in an explanatory report accompanying its initial proposal of November 2008, stated that given the specific nature of the activities of the credit rating agencies, the objective of regulation of the credit rating agencies on the internal market can be better achieved at the Community level- as the specific aspects of the business of the credit rating agencies is considered that a credit rating, once issued, can be freely used by any entity on the internal market, particularly by regulated financial institutions and investors. As there is a substantial level of reliance on the credit ratings among investors and financial institutions, the credit ratings available should meet certain standards, and their users - "investors and markets" - should be adequately protected. This reasoning provided by the Commission is somewhat expanding the current use of the "consumer and investor protection" vested with the protection of non-professional retail investors. The explanation of the Commission and the final wording of the Regulation basically say that it is necessary to protect not only non-professional investors, but also financial institutions, as they are (likely) not sophisticated and experienced enough to independently assess risks associated with their investments, and to "blindly" rely on opinions expressed by the credit rating agencies. Though the Regulation is part of measures taken in response to the financial crisis, where definitely a number of the financial institutions, particularly banks, have dramatically underestimated theirs risk exposure, it may be questionable whether literally expanding investor protection concepts to financial institutions is the most appropriate approach to tackle these failures.

In the assessment of proportionality, the Commission provided an explanation in its initial proposal that the regulation should target only those credit rating agencies whose credit ratings are used by financial institutions for regulatory purposes. The issue of "use for regulatory" purposes is dealt with later in this article, but let's focus on the Commission's assumption. By definition, once the credit rating is issued and is accessible to the public, i.e. to a large number of potential users, the credit rating agencies cannot control how or by whom these credit ratings are used. Hence, any credit rating agency may be brought under this regulatory regime, as by itself it does not have any available effective means as how to prevent users using credit ratings for certain purposes. It is similar to the situation of how an issuer of materialised securities cannot prevent the owners of the "paper" securities being handed over from using such securities for any legitimate or illegitimate purpose. It is definite that a more appropriate means to prevent certain behaviours of certain entities is to regulate specifically such specific behaviours directly. On the other hand, let's take the Commission position - the credit rating is a specific "product" which must be regulated in order to minimise potential harm to its users. This reasoning will probably sound familiar to those experienced with EU food and toys standards, which are commonly based on article 95 of EC Treaty, but may require a bit more thought from those familiar with the financial markets.

The case of this Regulation using as a legal basis solely article 95 of the EC Treaty is sending a clear signal on the expanding interpretation of the nature of measures which could be taken under the provision of the EC Treaty on the approximation of law and provisions on consumer protection in the financial services area. This precedent though may be somewhat of a concern - it should always be very cautiously considered whether consumer protection is really the right focal point of any regulatory measure, as well as to whether expanding standard "consumer protection" approaches to sophisticated financial institutions is the most adequate. At the end of the day - the complete "control and command" system of rules imposed by public administrations on commercial entities has not been found to be the most advantageous - as of yet. And that leads to the question of whether this time the Community institutions have really impartially assessed the case in the light of proportionality and subsidiarity principles.

 

What is Covered by New Regime and What and Who is Regulated?

The scope of the initial Commission's proposal and of the final approved Regulation is two-fold. Firstly, the Regulation sets out conditions for the registration of credit rating agencies and for their operations in the Community and establishes a system of supervision of credit rating agencies. Secondly, they articulate certain obligations for some of the users of the credit ratings. Having the single legal base of article 95, this may create some tension in the text of the Regulation, as the regulation is intended to apply to credit ratings, i.e. "products", but also effectively regulates credit rating agencies and their business.

The new regime requires all credit rating agencies which are legal entities established in the Community, and which issue credit ratings disclosed publicly or distributed by subscription, to obtain registration in the Community. There are certain exemptions from the scope of the Regulation for entities based in the Community which fall under a certain type of an entity and/or engage in certain type of credit rating activities. Exempted are central banks producing credit ratings paid for exclusively by users and export credit rating agencies. Also excluded are the issuances of private credit ratings, i.e. ratings which are not disclosed publicly or distributed by subscription - which is more a re-confirmation of the scope than a specific exemption. Credit rating agencies established outside the Community may be subject to certain requirements under the Regulation, provided that the credit ratings they issue are used for regulatory purposes by certain financial institutions in the EU (see below).

The second group of entities affected by this Regulation consists of financial institutions using credit ratings for regulatory purposes and entities responsible for securities prospectus in cases of public offerings of securities and admission to trading on regulated market. The Regulation requires these financial institutions to use for regulatory purposes exclusively credit ratings issued by credit rating agencies established in the Community and registered in accordance with the Regulation. The use of credit ratings for regulatory purposes should be understood as (i) use of credit ratings by banks for purposes of calculation of capital requirements under the Capital requirements directive, (ii) use of credit ratings by insurance and re-insurance companies for purposes of calculation of solvency requirements under the new Solvency II directive, (iii) use of credit ratings by investment firms under MiFID for determination of eligible money market instruments for the depositing of clients funds, (iv) use of credit ratings by UCITS funds under UCITS directive for determination of eligible non-listed money market instruments and securities and money market instruments containing certain embedded derivative components the UCITS can invest in, and (v) use of credit ratings by harmonised institutions for occupational retirement provision under the IORP directive. The use of credit ratings is not currently explicitly referred to in the IORP directive. Some member states have introduced certain rules on the use of credit ratings for determination of technical interest rates and investment purposes by institutions for occupational retirement provision. As these additional rules governing the use of credit ratings by institutions for occupational retirement provision do not stem directly from the IORP directive it may be unclear whether this case of the use of credit ratings should be considered as the use for regulatory purposes under the Regulation. In case the Solvency II regime is also extended to institutions for occupational retirement provision, the rules for the use of credit ratings under such a regime should be considered as use for regulatory purposes.

In respect to persons responsible for the content of the securities prospectus, the Regulation requires them to include prominently specific information as to whether or not the credit rating referred to in the prospectus is issued by a credit rating agency established in the Community and registered under this Regulation. This information may be understood as a form of a quality label informing readers of the prospectus as to whether the rigorous procedures set out in the Regulation have been complied with and whether the relevant credit rating agency is subject to supervision in the Community. Such information investors may eventually utilise in cases where they are making complaints in respect to the credit rating in question.

 

Third Country Credit Ratings

The Regulation restricts the use of credit ratings issued in third countries for regulatory purposes in the Community only to such credit ratings compliant with certain specific requirements. The initial Commission proposal allowed use of third country credit ratings for regulatory purposes in the EU. After heated discussion in the Council and the European Parliament, two specific procedures ensuring certain qualitative standards and a supervisory regime were introduced. The main purpose for the introduction of these procedures was to ensure that only credit ratings produced under certain strict conditions and accompanied by relevant information are made available for use for regulatory purposes in the EU.

The first of the specific regimes for third country credit ratings is the Endorsement which represents the assumption of a credit rating issued by third country credit rating agency by a credit rating agency established and registered in the Community, thus becoming responsible for the endorsed credit rating in the same way as for a credit rating issued by itself in the EU. There is an extensive set of conditions in respect to the third country credit rating agency and the third country regulatory regime which should be fulfilled and checked by the endorsing credit rating agency. The main conditions are that the third country credit rating agency is part of the same group as the endorsing credit rating agency and has adopted measures which ensure compliance with similar requirements for the issuance and dissemination of credit ratings as imposed on credit rating agencies registered in the EU. The Regulation also requires that the third country credit rating agency is registered or authorised and subject to supervision, the third country regulation prevents interference of public authorities in the objectivity of the credit ratings and that there exists cooperation arrangements between the competent authority of the third country responsible for supervision of the third country credit rating agency and the home competent authority of the endorsing credit rating agency.

The other regime for third country credit ratings is structured in two processes - Equivalence and Certification. The Equivalence means that the Commission has adopted an equivalence decision recognising the legal and supervisory framework of a third country as equivalent to the requirements of the Regulation, i.e. such a regime requires registration or authorisation of credit rating agencies, establishes supervision of their activities and prevents interference of public authorities with the content of credit ratings and methodologies. The Certification represents a lighter version of standard registration procedure and enables third country credit rating agencies issuing credit rating which do not have significant impact to the financial stability, or integrity of the financial markets of one or more member states, and the complexity and scale of the business of the credit rating agency in question is not large. In such cases third country credit rating agencies may be exempted from compliance with certain requirements, such as establishment of a physical presence (subsidiary) in the Community. Also in case of certification there is a requirement on the establishment of cooperation arrangements among third country competent authorities and relevant European competent authorities.

The former regime had been designated primarily for the initial stage of the application of a new regulatory regime for credit ratings in the EU - until decisions on equivalence are made in respect of major jurisdictions, which later should enable relatively more flexibility for credit ratings issued by credit rating agencies established in countries deemed to have an equivalent regulatory regime as those to be used for regulatory purposes in the EU. Secondarily though, as was discussed during the negotiation, was that credit rating agencies whose credit ratings may have significant impact on the European financial markets should always have physical establishment in the Community in order to be supervised directly by the competent authorities from the EU and eventually to be held responsible for complaints of users of their credit ratings.

The introduction of these specific procedures for third country credit ratings to be used in EU for regulatory purposes may unfortunately lead to a sort of protectionist regime. The equivalence regime which is accompanied by strong additional requirements for certification may to a significant level eliminate the benefits of equivalence as a form of mutual recognition of regulatory standards among countries, and generally, recognition of compliance with global standards. It can be also interpreted as an move to create a stricter equivalence regime as opposed to the current regime in other areas of financial services, namely for the securities prospectus and the transparency of listed companies into a much stricter approach; de facto creating extraterritoriality effects in third countries outside the EU.

 

Supervision of Credit Rating Agencies

A particularly specific feature of the new regulatory regime for credit rating agencies is the structure and functioning of the supervision of credit rating agencies in the EU. The specific nature of the activities of credit rating agencies which may issue credit ratings in one member state, and hence these credit ratings can be subsequently used in all other member states, calls for close cooperation among competent authorities of all member states affected. The supervisory system for credit rating agencies is based on colleges. The initiative to establish a college is with the home member state of the credit rating agency applying for registration. Unlike colleges of banking supervisors which consists only of competent authorities where branches and subsidiaries of a consolidating bank are established, the colleges supervising credit rating agencies are "inclusive". This means that competent authorities of any member states where the use of credit ratings for regulatory purposes issued by a credit rating agency is wide spread, or has or is likely to have significant impact, may join the college as it is being formed, as well as at any time afterwards. Also competent authorities from other member states may take part in meetings of the college and its activities though they have only a consultative role in decisions made by a college.

The functioning of the college is also unprecedented. The Regulation provides for detailed rules for the establishment of a college and for the selection of the "facilitator" of the college. The role of facilitator is to chair meetings of the college, coordinate actions of the college and to ensure efficient exchange of information among members of the college. There is a specific procedure for selection of "facilitator" by members of the college - the Regulation sets out certain criteria which should be taken into account by the members of the college, such as the relationship between the credit rating agency and relevant competent authority, the places in the Community where the most important part of the credit rating activities are to be carried out, or the extent to which the credit ratings will be used for regulatory purposes in a particular territory. For the most part, the competent authority of the home member state of a credit rating agency should be selected as facilitator, but in some circumstances the selection may be different. There is also a built in review process for the selection of facilitator every five years. The Regulation also requires the establishment of written coordination arrangements for the functioning of the college based on the blueprint drafted by CESR.

The crucial role of the college is in registration procedure, where all members of the college are involved in the examination of the application and the development of the common position of the college regarding the eligibility of an applicant to be registered or not. Subsequently, the competent authority of the home member state drafts the decision on whether to grant or refuse registration and submits such draft decision and the common position of the college to CESR, which again assess the compliance of the credit rating agency with the requirements set out in the Regulation. Following the reception of CESR's opinion, the members of the college re-examine the draft decision. Then the home member state competent authority drafts the final decision. The Regulation constructs very specific requirements for granting of registration to a credit rating agency - for the positive decision issued by home member state competent authority there must be a full unanimous consensus of all members of the college on the compliance of the applying credit rating agency with the requirements set out in the Regulation. In case of disagreement among members of the college in respect to compliance of the credit rating agency in question with the requirements for registration, the registration cannot be granted.

Though day to day supervision of credit rating agencies is vested with national competent authorities, in particular with the home member state competent authority, the colleges do have important role to play. Colleges primarily represent a platform for the coordination of activities of member competent authorities (e.g. inspections, monitoring etc.), efficient exchange of information and a conduit for consultations among members. The colleges are also involved in assessing that the conditions for endorsement and equivalence and certification are fulfilled. There are specific procedures for the consultation of the college in case breach of the Regulation is determined and the competent authority of the home member state or the competent authority of another member state intents to adopt certain supervisory measures or to withdraw a registration. These procedures are similar to the process of registration save there is no condition of an unanimous opinion of the members of college binding the competent authority in question to issue a specific decision.

Apart of introducing a specific college regime for the coordination of supervision, the Regulation endorses the central coordination and harmonisation role of CESR. Similarly to other Lamfalussy directives, CESR is entrusted with the issuance of number of guidelines providing for convergent interpretation and application of the Regulation by competent authorities throughout the Community. The strengthening of the coordination role of CESR, also compared to other level 3 committees (CEBS, CEIOPS), is clearly visible from applying it with the function of a "single-entry point" for all applications made by credit rating agencies. It is also entrusted with competence to assess the completeness of an application, and subsequently, the assessment of thecompliance of applying credit rating agency with requirements for registration. The opinion of CESR should always be taken into account by competent authorities and, whenever they depart from the opinion of CESR in their decision making, they should provide a full explanation for such divergence. CESR has an important role in the process of the establishment of colleges giving an opinion on coordination arrangements for the functioning of the college.

Another enhancement of the CESR role is that CESR should also be informed on cross-border cooperation among competent authorities from different member states in respect to inspections and investigations. Member states' competent authorities may also request CESR to assume a coordination role in cross-border inspection or investigation. Under the Regulation CESR also is assuming a mediation role for settling disputes among competent authorities on an assessment, or actions in respect to credit ratings and credit rating agencies which should be conducted under the Regulation.

 

Conclusions

The new Regulation on credit rating agencies responses to a number of calls for statutory regulation of the credit rating industry and the establishment of sound rules for functioning of credit rating agencies, sets a clear standard for disclosure and the presentation of credit ratings and last but not least, for the adequate supervision of credit rating agencies. It also reflects certain lessons learned from the financial crisis. As this is the first time the European Union is creating full scale regulations of the credit rating industry there have been number of diverging views on the most appropriate way on how to regulate credit rating agencies. Calls for urgent action at the Community level, in respect to credit ratings, and ongoing parallel discussions and legislative initiatives (such as the issue of an EU regulatory infrastructure) induced by financial crisis, have affected the choice of regulatory instruments and methods, thus resulting in an unique solution compared to the Community regulation of other sectors of financial markets. It may be questioned whether the form and method used is the most appropriate one, but the Regulation laid out certain new regulatory solutions in which their effectiveness and robustness will need to be tested in practice.

Certain innovative aspects of this Regulation can be found in legally basing the Regulation solely on article 95 of the EC Treaty dealing with the approximation of laws which aim at the establishment and functioning of the internal market, and which have been mostly used in respect to measures concerning the protection of consumers, environment and health rules. As currently all EU financial market rules consists of framework directives building on the right of establishment, the use of article 95 as basis for setting out the legislative framework for the entire credit rating industry in the Community can imply a potential shift in the approach to Community legislative adoption in respect to financial markets, to make more use of directly applicable rules (i.e. regulations instead of directives) and making the primary interest of such legislation the protection of internal markets and consumers. The legal basis may also better explain the two-fold scope of the Regulation, on one hand regulation of the activities of credit rating agencies and on the other regulating the use of credit ratings by certain financial institutions and the obligation to include certain "country of origin warnings" for consumers in case of credit ratings presented in securities prospectuses. This move in "regulatory paradigm" may be to some extent an understandable reaction to the financial crisis, but it must be prudently assessed from the long term perspective in order not to create an over-prescriptive environment for business, too rigid of barriers for new entrants to competition and the restricting of consumers' choices and access to information.

Another feature which may be described as innovative is the regulatory approach toward credit ratings issued in third countries. Compared to the approach taken in respect to financial information on securities issuers and accounting standards, the Regulation introduces a much more elaborate and prescriptive regime for credit ratings issued outside the Community, requiring not only full compliance of these credit ratings with the EU standards but also the de facto compliance of the third country credit rating agencies with these standards. As global standards for credit ratings are only evolving, and not all major jurisdictions may propose regulatory regimes identical with the European one, the current form of the EU regulatory regime for credit rating agencies may not contribute much to the creation of much needed global standards for credit ratings, and the credit ratings and their use can be virtually global. Solutions contained in the Regulation may lead to the interpretation that, in respect to any third country regulatory regime for any financial sector, a much more prudent approach may be required and "plain" equivalence assessment of an overall regime for the relevant sector of the financial market in a third country may not be sufficient. Instead, specific case by case review of compliance with EU standards by a financial institution, financial instrument or information may be required.

Thirdly, the European supervisory debate has influenced strongly the shape of the supervisory system for credit rating agencies. The Regulation is not deploying a "standard" service passport regime for credit rating agencies and a product passport for credit ratings subject to assessment and approval/non-objection by the home member state competent authority and the host member state competent authority. Instead the single registration process conducted by the college of competent authorities from all member states where credit ratings issued by a credit rating agency in question may be used for regulatory purposes. The inclusive colleges represent very new concept of cooperation among competent authorities in the Community. The procedural issues addressed by the Regulation rules governing the exchange of information, delegation of tasks and coordination of day to day supervisory business may be seen as an potential inspiration for forthcoming rounds of discussion on the shape and functioning of the European supervisory agencies.

 

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