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Credit Rating

Agencies

Public and Private Uses of Credit Ratings

Christopher C. Nicholls

May 25, 2005



Four topics of investigation

Public (legislative and regulatory) uses of creditratings

Private (uncontracted-for) uses of credit ratings

Potential liability for credit rating agencies

arising from private use of ratings

Alternatives to the use of credit ratings



Public (or Regulatory) Uses of

Credit Ratings Such use documented in U.S.

See, “Financial Oversight of Enron: The SEC and Private-Sector Watchdogs”, Report of the Staff of the Senate Committee on Governmental Affairs (October 8, 2002) at101 ff.

SEC, “Report on the Role and Function of Credit Rating Agencies in the Operation of Securities Markets” (January 2003) at 28.

And Internationally See, e.g., Basel Committee on Banking Supervision, “Credit Ratings and

Complementary Sources of Credit Quality Information” (July 2000) at 41 ff.

IOSCO Report on the Activities of Credit Rating Agencies (September 2003)

Gonzalez et al., “Market Dynamics Associated with Credit Ratings” (European CentralBank, June 2004) at 9.

2004 AMF Report on Rating Agencies (January 2005) at 37 ff.



Initiatives

Europe:

European Parliament Resolution (Feb. 2004)

CESR Report to EC (March 2005)

IOSCO

Statement of Principles Regarding Credit Rating Agencies Code of Conduct Fundamentals for Credit Rating Agencies

(2004) (“comply or explain” approach)



Critical role of credit-rating agencies hasrecently led to:

Proposed Exchange Act Rule 3b-10 (re: “NRSRO’s”)

Proposes defining “NRSRO” in terms of 3 components:

Free Public Availability/Current Assessments ofCreditworthiness

Market Acceptance Systematic Procedures (reliability, manage conflicts, prevent

misuse of confidential information) and Adequate Resources



Suggestions in the U.S. that legislativeauthority to oversee credit rating agencies

might be appropriate.(See William H. Donaldson, “Testimony

[before the Senate Committee on Banking,Housing, and Urban Affairs] Concerning the

State of the Securities Industry” (March 9,2005)



Public Use of Credit Ratings

U.S. In U.S., credit ratings referenced in at least 8 federal statutes, 47 federal

regulations, and more than 100 state-level acts and regulations (SeeCovitz & Harrison, 2003; Report of the Staff of the Senate Committee on Governmental Affairs)

Canada Federal At least 8 federal statutes (or regulations)

Bank Act Canada Marine Act Canada Small Business Financing Act Civil Air Navigations Services Commercializations Act Co-operative Credit Association Act Income Tax Act Canadian Payments Act



Provincial Legislation (other than

Securities laws) At least 37 provincial statutes (or

regulations) in addition to securities laws

in which the concept of credit ratings orapproved/recognized credit/bond ratingagency is used



Selected Examples of Regulatory

Uses Investment Eligibility

Proxy for Creditworthiness

Net Capital and Prudential Regulation Specific Unique Examples:

E.g., Mine Development and Closure Regulations(Ontario)

Cross Border Leases Relating to Toronto Transit

Electrical Power Control Act



Provincial Legislation (Securities

Laws) At least 10 National Instruments or

National Policies use concept of approved

credit ratings

Also included in a number of provincial

securities rules and regulatory instruments



Selected Securities Law Uses Exemption from s. 76 (s.76(2)-”other than in the necessary course of

business”; NP 51-201, s. 3.3(2)(g), 3.3(7))

Exemption from s. 130 statutory civil liability (Rule 41-501, s.13.4(4); s. 130(1)(d))

Eligibility for use of Short Form Prospectus for certain debt and prefshare issues (NI 44-101)

Eligibility to distribute securities under MJDS (NI 71-101, s. 3.1(a))

Requirements for money market funds (NI 81-102, s. 1.1 (definitionof “money market funds” and s. 15.3(5),(6))

Proposed NI 45-106, registration and prospectus exemption forcommercial paper (NI 45-106, s. 2.36(1), (2))



“…[credit] ratings form part of the

statutory framework of provincialsecurities legislation…” National Policy 51-201, s. 3.3(7)



Private Uses of Credit Ratings

“Ratings Triggers”

Issues: Propriety of using ratings triggers Effect of rating triggers on rating of issuer (the

“circularity” problem) The “forced seller” problem

Does existence of triggers make CRAs reluctant todowngrade? Disclosure issues (In US-Reg FD exemption)



Ratings Triggers

Issue Studied by CRA’s, see, e.g.:

“The Unintended Consequences of Ratings Triggers”(2001)(Pamela Stumpp (Moody’s) )

"Moody's Analysis of US Corporate Rating Triggers HeightensNeed for Increased Disclosure“ (2002)

“Identifying Rating Triggers and Other Contingent Calls onLiquidity”(2002) (Solomon Samson (S & P) )

“Few European Firms Hang at Credit Cliff” (2002) (S&P)



Ratings Triggers

Among most well-known uses are: Default/acceleration triggers in loan agreements

Pricing “grids”

Security/collateral enhancement triggers

Benchmark for triggering restrictive negative covenants

For calculation of borrowing base, and “springing liens”

Qualification of permitted assignees



Liquidity Implications

Reporting issuers must disclose in liquidityportion of M D & A, ratings triggers that

could “trigger an additional fundingrequirement or early payment” or that

“could impair your company’s ability to

undertake transactions” Form 51-102 F1, Part 2, item 1.6, instruction (ii)



Other Triggers

Other triggers—such as those affectingpricing—might not be required to be

disclosed in M D & A and yet may, inaggregate, be material to an issuer

Not just downgrades that may adverselyafffect issuers



Potential Civil Liability for CRAs

Two principal potential sources of liability:

Action brought by rated issuer

Action brought by third party users of ratings



Potential Civil Liability

Threat of action by rated issuers could(theoretically) pressure CRAs to be more

sanguine in their ratings decisions

Threat of action by third-party users could

(theoretically) pressure CRAs to be moreconservative in their ratings decisions



Liability to Third Parties

Risk of Liability for CRAs to third partyusers of ratings is low

Under securities laws, CRA’s largely

insulated from statutory civil liability (e.g.,

Ontario Securities Act s. 130)



Liability of CRAs

Common law: Debatable whether prima facie duty of care under first

stage of Anns/Kamloops

Even if prima facie liability under first stage, risk ofindeterminate liability negatives duty under secondstage (Hercules Mangements)

Even if possible liability under Anns/Kamloops , CRAstypically responsibility (Hedley Byrne)



Alternatives to Credit Ratings

From SEC Concept Release 33-8326: Allow the use of internally-developed credit ratings (by broker-

dealers) (Conflicts?) Industry SRO’s could set appropriate standards For investment eligibility purposes, subjective tests could replace

credit ratings (i.e., prudent investment standards)

For short-form registration (Form S-3), other tests such asinvestor sophistication, denomination size, and (in case of ABSdeals) specified asset and structure experience criteria

Coverage Ratios?

Credit Spreads?



Alternatives to Credit Ratings

Private contracts: If market regarded alternativesas superior to credit ratings, alternatives wouldbe used

Regulatory uses: Alternatives such as creditspreads may not be an adequate substitute forcredit ratings because:

Too volatile—too many “false negatives”? [Stability isvalued for credit ratings] Information asymmetry



Conclusion

Public and private uses of credit ratings are useful, no superior alternative to creditratings for these purposes exists, and such use should not be discouraged

Legislative and regulatory use of credit ratings originally simply a reflection of marketreality, but now impacts the market

CRAs fundamentally different from registrants

Regulation through control of designation—with only sanction a removal ofdesignation—places regulator in relationship with CRA similar to CRA’s relationshipto rated issuer

However, no single regulatory or legislative recognition of “approved credit rating

agencies” for Canadian purposes

Further, given the recognition of CRAs as NRSROs in the U.S., and ECAIs for BISpurposes, unlikely that Canadian regulators can (or should) act unilaterally.

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